Most people save for retirement with the help of their employer's retirement plan—typically a 401(k) offered as part of an employee benefits package. If you're self-employed or the owner of a small business, you're the employer—so you need to provide your own retirement plan. Enter the SEP IRA, or Simplified Employee Pension plan.
Like other traditional retirement accounts, SEP IRAs let you defer taxes on contributions and any investment growth in the account. Although withdrawals in retirement will be taxed as ordinary income, the potential for decades of compound growth without current taxation makes it possible to accumulate a much larger nest egg than you could in an ordinary, taxable brokerage account.
SEP IRAs are available to businesses of all sizes, but they tend to be best suited to self-employed individuals, small-business owners, or members of a partnership. Their main selling points are low cost and simplicity: They entail fewer administrative responsibilities than other types of retirement accounts, and typically don't impose start-up costs or annual fees. On the other hand, they carry restrictions that may not suit larger businesses.
SEP IRAs are funded only by employer contributions; employees can't contribute on their own behalf. The accounts let you set aside much more money than most other retirement accounts; in 2019, you can contribute up to $56,000 or 25% of your eligible compensation, whichever is lower. (In 2018, the limit was $55,000.)
This advantage comes with an important caveat for business owners with employees. If you set up a SEP IRA for yourself, you also must establish one for each eligible employee (or have employees set up their own). And if you contribute for yourself in a given year, you have to contribute the same percentage of salary to each eligible employee's account as well.
The ability to contribute as much or as little as you want in a given year can be appealing. You can choose to make larger plan contributions during profitable years and smaller contributions in down years—and even skip contributions altogether in truly bad years. Such variations in contribution levels don't trigger additional paperwork; you just need to make sure that in years you make a contribution, you contribute the same percentage of salary to each eligible employee's account.
As with regular IRA contributions, you have until the tax filing deadline to make SEP IRA contributions for a given calendar year—potentially as late as October of the following year if you've filed a tax extension.
A simple retirement solution
Establishing a SEP IRA is relatively easy and straightforward. Most financial institutions that offer retirement accounts provide SEP IRAs, and setting one up takes only slightly more work than opening a traditional IRA.
Once the account is funded, you and any employees can invest the money in any of the investment options offered by the account provider. SEP IRAs typically offer many more investment options than other workplace plans, such as 401(k)s or 403(b)s, giving you and your employees greater flexibility to design portfolios that suit your needs. The accounts have the same investment limitations as ordinary IRAs, including restrictions on collectibles, coins, real estate that you derive a direct benefit from, and certain types of derivative positions.
Administering a SEP IRA is simple and inexpensive. You do not need to fill out the IRS Form 5500, as you do with several other small-business retirement savings accounts. That said, providing a SEP IRA to eligible employees does involve some responsibilities. Employers must have a record of the plan agreement on file (though it does not need to be filed with the IRS). The IRS recommends, but does not require, using Form 5305 for this purpose. You are required to have a written agreement with employees that outlines the details of the plan and notes the dates of contributions to their accounts.
Access to assets
Employees are fully vested in any SEP IRA assets as soon as you contribute money to the account—something to consider if you want to use the account to retain valuable employees. The rules governing access to the assets are similar to the rules for traditional IRAs:
- Withdrawal of funds prior to age 59½ may be subject to a 10% early withdrawal penalty, along with any applicable income taxes
- You can make a withdrawal from your SEP IRA prior to age 59½ without incurring the early withdrawal penalty in specific circumstances, including financial hardship, higher education expenses, or a first home purchase
- You can't borrow from a SEP IRA
- You can roll your SEP IRA assets into another IRA
- You can roll assets from another retirement account into your SEP IRA
- You must take required minimum distributions from SEP IRAs beginning at age 70½
If you're self-employed, there's a good chance a SEP IRA offers the best combination of features, including cost, flexibility, investment options, and contribution limits. The decision becomes more complicated if you have employees: In that case you need to weigh the account's appealing features against the mandate to contribute for your workers whenever you contribute for yourself. If that requirement is not onerous, this account may provide an appealing way to save for your own retirement while offering employees an attractive benefit.
For more on SEP IRAs, visit the IRS website.