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Understanding the SEP IRA

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.

A SEP IRA is an account that, like other traditional retirement accounts, lets you as the employer 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 IRA contribution limits

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.

Contribution caps for SEP IRAs can vary each year between 0% and 25% of compensation (maximum $66,000 for 2023 and $69,000 for 2024). Each eligible employee must receive the same percentage.

The maximum compensation that can be considered for contributions in 2023 is $330,000. Self-employed individuals can calculate their compensation for the purpose of SEP IRA contributions as the lesser of 1) their net earnings from self-employment minus half of their self-employment tax or 2) the SEP IRA contribution for the calendar year.

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.

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How to set up a SEP IRA

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. 

You must set up an account for each eligible employee. Keep in mind, if you offer a SEP IRA, you cannot offer additional separate retirement plans

SEP IRA rules

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 health insurance premiums paid while unemployed, higher education expenses, or a first home purchase, up to a lifetime limit of $10,000
  • You can't borrow from a SEP IRA
  • You can roll your SEP IRA assets into another IRA or employer plan, subject to some restrictions depending on the receiving account or plan
  • You can roll assets from another retirement account into your SEP IRA

Potential Drawbacks of SEP IRAs

SEP IRAs are not ERISA plans and do not offer the same level of creditor protection. IRAs are protected in the event of bankruptcy under federal law, but additional coverage varies by state. Consult your tax advisor for details regarding the laws within your state. Additionally, while it can be beneficial to manage SEP IRA contributions based on business profitability, it can be frustrating when contribution limits tied to compensation prevent you from making your desired contribution. Unlike some plan types, SEP IRAs do not offer loans. Depending on your situation, keep other retirement plan types in mind such as SIMPLE IRAs, Self-Employed 401(k)s, and Pooled-Employer-Plans that may address these concerns.

The bottom line on SEP IRAs

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.

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Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

*You are always able to take money from your IRA. Some withdrawals may be taxable and some may be subject to a 10% early withdrawal penalty. If you are over age 59½, you aren't subject to a 10% early withdrawal penalty.

Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.

This information is intended to be educational and is not tailored to the investment needs of any specific investor.

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