SEP IRA

Key Takeaways

• SEP IRAs allow employer contributions up to 25% of compensation or $70,000 for 2025 (whichever is less), providing substantially higher limits than traditional IRAs
• Contributions are made exclusively by employers, not through employee salary deferrals, making SEP IRAs simpler to administer than 401(k) plans
• Employers have discretionary contribution flexibility, allowing contribution percentages to vary year to year based on business performance, including zero contributions
• The same contribution percentage must apply to all eligible employees, including business owners, when contributions are made in a given year
• For 2025, compensation is capped at $350,000 for calculating maximum contributions, with employees earning $750 or more typically eligible
• Self-employed individuals face an effective contribution rate of approximately 20% due to self-employment tax and contribution deductions in the calculation
• SEP IRAs offer no catch-up contributions for workers age 50 and older, unlike 401(k) plans and traditional IRAs
• Roth SEP IRA options became available under SECURE 2.0 Act, though employer adoption remains optional and not all providers offer this feature
• Contributions can be made until the employer's tax filing deadline, including extensions, providing flexibility for end-of-year tax planning

What Is a SEP IRA?

A Simplified Employee Pension (SEP) IRA is a type of retirement plan set up by employers or self-employed individuals. Employers are able to take a tax deduction for amounts contributed to each employee's plan. Unlike many standard retirement plans like a 401(k), SEP IRAs offer discretionary contributions, meaning employers can choose how much they contribute to each employee within the required uniform percentage framework.

SEP IRAs were established to promote accessible retirement savings for small businesses and self-employed professionals. The structure eliminates many administrative burdens associated with traditional pension plans while maintaining tax advantages for both employers and employees. SEP IRAs are individual retirement accounts owned by employees, with employers making contributions on their behalf rather than employees deferring salary into the accounts.

SEP IRA Rules and Requirements

SEP IRAs were set up to promote retirement savings in small businesses. This makes a SEP IRA for S Corporations, Partnerships, Sole Proprietorships, and other small businesses common. There are a few notable rules and limitations to SEP IRAs, including:

Contribution Limits for 2025

SEP IRAs limit the amount that can be contributed each year. This limit is the lesser of 25% of the employee's compensation or $70,000 for 2025. Contributions are calculated based on compensation up to $350,000 for 2025. For self-employed individuals, the compensation base is net earnings minus the SEP contribution and the employer's share of self-employment taxes. Due to these deductions, self-employed individuals have a modified SEP IRA contribution base of approximately 20%. SEP IRA excess contributions must be withdrawn to avoid tax penalties.

The 25% contribution limit applies to employee compensation, while the effective rate for self-employed individuals is lower due to the calculation methodology. Self-employed individuals must first subtract half of their self-employment tax from net business income, then calculate the SEP contribution as a percentage of this reduced amount. This creates a circular calculation that results in an effective maximum contribution rate of approximately 20% of net self-employment income.

Employee Eligibility Requirements

To participate in a SEP IRA, employees must meet the following requirements:

• Be at least 21 years old
• Have worked for the employer in at least 3 of the last 5 years
• Have received at least $750 in compensation from the employer for 2025

Employers can choose to use less restrictive eligibility requirements, such as allowing all employees to be eligible immediately upon earning compensation. Plan documents specify the eligibility criteria adopted by each employer, which cannot be more restrictive than IRS minimums but may be more generous.

Employee Exclusions

SEP IRAs give employers the ability to exclude certain employees. For example, employers might choose to exclude nonresident aliens receiving no U.S. source income from the employer or workers who fall under a union collective bargaining agreement where retirement benefits were the subject of good-faith bargaining.

Withdrawals and Distributions

SEP IRA contributions can be withdrawn at any time; however, if individuals withdraw the funds before retirement age (59 ½), a 10% early withdrawal penalty typically applies in addition to ordinary income tax. SEP IRA accounts work in a similar manner to Traditional IRA accounts regarding tax treatment and qualified charitable distributions. Required minimum distributions (RMDs) generally begin at age 73 for individuals born between 1951-1959, while those born in 1960 or later will begin RMDs at age 75 (effective January 1, 2033).

Rollovers and Transfers

Individuals can rollover a SEP IRA to a Traditional IRA without tax consequences. If transferring a SEP IRA into a Roth IRA, taxes are owed on any pre-tax funds in the year of conversion. SEP IRAs can also roll into 401(k) plans, 403(b) plans, and other qualified retirement plans, providing flexibility for employees who change jobs or consolidate retirement accounts.

SEP IRA Contribution Calculation Example

Consider a self-employed individual with $100,000 in net self-employment income. Using this example, the maximum SEP IRA contribution calculation would involve the following steps:

1. Calculate Net Business Income: Revenue minus expenses equals $100,000 

2. Deduct Employer Share of Self-Employment Taxes: On $100,000 of business income, the employer's share of self-employment taxes is approximately $7,065 

3. Calculate Modified Business Income: $100,000 minus $7,065 equals $92,935 (SEP base) 

4. Calculate Maximum Contribution: $92,935 multiplied by 20% equals approximately $18,587

Using a SEP IRA contribution calculator or working with a tax professional can help determine the precise maximum contribution based on individual circumstances. The calculation becomes more complex when considering additional factors such as health insurance deductions for self-employed individuals or other adjustments to net earnings.

Considerations for SEP IRAs

SEP IRAs are commonly discussed as an option for small employers because they are affordable to set up compared to traditional employer plans. Additionally, employers have discretion over how much they contribute to employee accounts each year. Another advantage is a higher potential contribution limit compared to other retirement plans, like a Traditional IRA.

One consideration for self-employed individuals is that the maximum contribution amount may not be determined until the tax return is filed. This is why the IRS allows contributions to be made until the return is filed for that tax year. Specifically, SEP IRA contributions can be made up until the employer's tax filing deadline, including extensions.

SEP IRAs lack catch-up contribution provisions for workers age 50 and older, contrasting with 401(k) plans and traditional IRAs that allow additional contributions. For self-employed individuals considering retirement plan options, this absence of catch-up contributions may factor into comparative analysis with Solo 401(k) plans, which do permit catch-up contributions.

The uniform contribution requirement mandates the same percentage contribution for all eligible employees when any contributions are made, therefore it can become costly for employers with many employees. Business owners must weigh the tax deduction benefit against the total cost of contributing to all eligible employees' accounts when deciding whether to make contributions in a given year.