Everything You've Ever Wanted to Know About a SEP IRA

A SEP IRA—shorthand for Simplified Employee Pension IRA—is a retirement savings vehicle for self-employed folks. It comes with some nice perks, which can make it a great option for business owners who don’t have access to an employer-sponsored plan.

It’s more than possible to build your nest egg while working for yourself. That’s where a SEP IRA can come in handy. Here’s how it works.

How is a SEP IRA Funded?

A SEP IRA lets you sock away tax-deferred dollars for retirement and is funded with employer contributions. So if you’re self-employed or own a business, you could establish a SEP IRA and begin saving for your future. The money you put in is tax deductible for the business; an added bonus. When you’re ready to tap your SEP IRA, distributions will be taxed as regular income. A 10% penalty will likely be tacked on if you’re under 59½.  

One important note: The IRS says that if you have employees who are also eligible to participate, you’ll be required to make equal contributions on their behalf. Eligible employees are workers who:

  • Are 21 or older

  • Have worked for the company in at least three of the last five years 

  • Have earned a minimum of $650 of compensation in 2022

Like a traditional IRA or 401(k), money that’s invested in a SEP IRA grows tax-deferred until you withdraw funds in retirement. Distributions are then taxed as ordinary income.

Contribution Limits

The SEP IRA’s high contribution limit is one of its biggest draws. In 2022, you can kick in up to $61,000 or 25% of your compensation; whichever is less. (That 25% is based on the first $305,000 of compensation.) That’s a lot more than traditional and Roth IRAs, which only allow you to contribute up to $6,000 annually across all your IRA accounts. That number jumps up to $7,000 for folks who are 50 or older. SEP IRAs, meanwhile, do not allow for catch-up contributions

When Does a SEP IRA Make Sense?

A SEP IRA can be smart for business owners and self-employed workers who are looking to dial up their retirement savings. Its high contribution limit might help you put more muscle behind your nest egg. That gives it a leg up over traditional and Roth IRAs. The main difference with a Roth is that it’s funded with after-tax dollars. That means distributions you take in retirement are tax-free.

The main drawback of a SEP IRA is that you’ll also be expected to make equal contributions for eligible employees. So if you’re contributing 15% to your SEP IRA, you’ll also have to fund each eligible employee’s SEP IRA with 15% of their compensation. If you have a small team or are running a one-person operation, a SEP IRA could make a lot of financial sense.

How A SEP IRA Works with Other IRAs

A SEP IRA isn’t the only way to save for retirement. Self-employed folks can also kick into a traditional IRA. Like a SEP IRA, your investments grow tax-deferred until you retire. (You’re taxed when you withdraw the money.) You can also contribute to a 401(k) if you’re still working for an employer that offers one.

Contributing to a Roth IRA is on the table as well, assuming you’re under the income threshold. It might be nice to have a pile of tax-free money waiting for you when you retire. A backdoor Roth IRA conversion could be worth considering here. It involves taking a distribution from your SEP IRA, paying taxes on it today, then depositing the rest into a Roth IRA. You’ll sidestep that 10% early withdrawal penalty—and it’s a smart financial move if you expect your tax bracket to be higher in retirement than it is today.

Saving for Retirement When You’re Self-Employed

Saving for retirement is pretty straightforward when you work a traditional 9-to-5. Most employees set up automatic 401(k) contributions and go from there. A SEP IRA can be a great starting point for self-employed folks. One potential drag is the cost of funding employee IRAs. In this case, a solo 401(k) could be a good alternative. It works like a traditional 401(k), but you can contribute two ways—as both the employee and the employer.

What we’re getting at here is that self-employed workers do have options when it comes to saving for retirement. A SEP IRA is a great fit for some but may not make sense for others. Like all financial stuff, it really depends on your situation. We’re here to walk you through the nuances if you need a hand.

AJ Grossan