What Is a SEP IRA?

Thinking about the future is essential if you want to rest when you retire. However, the best way to save money for the future is to invest in a retirement account, and many either don’t know how that work or think retirement account rules are not fair for them.

Regardless of which side are you on, creating a SEP IRA could solve all your problems.

This retirement plan focuses on self-employed individuals and people with small businesses who can’t get into the retirement plans that people with bigger companies have access to. However, you need to understand how to set up a SEP IRA and its rules before trying it, and that’s what this article is for.

Read this page if you want to learn more about how SEP IRAs work and how to know if you are eligible for one. Even if you don’t qualify for one, knowing how this works helps you understand other retirement plans that could fit you better.

Table of Contents

What Is a Simplified Employee Pension IRA?

A Simplified Employee Pension Individual Retirement Account or SEP IRA is a retirement account for self-employed individuals such as freelancers or small business owners with a short list of employees. In a nutshell, this retirement plan works for people with an independent income.

Many employers prefer going for SEP IRAs instead of other retirement plans due to how easy it is to manage them, so they don’t have to worry about making mistakes throughout the process.

Since many industries have a cyclical nature, SEP IRAs help employers make the contributions they want and when to make them without employees making contributions.



As happens with other retirement accounts, SEP IRAs have their own rules to decide who is an eligible employee for a SEP IRA account. This is the first thing to study when starting to think about your retirement savings since it tells you if you can enjoy the retirement benefits of a SEP plan or if you need to go for a traditional IRA.

Although this is common in a traditional IRA, anyone applying for a Simplified Employee Pension IRA needs to be 21 years old or older.

Employees applying for SEP IRAs also need to know they can’t make contributions to the account, unlike what happens with a traditional IRA. Apart from that, those employees need to have worked for you for three years or more. Funds-wise, an eligible employee must have earned $600 from your business in 2016-2020 and $650 in 2021 and 2022.

SEP IRAs are not all about restrictions and offer you more flexibility than a traditional IRA or a Roth IRA. You can skip contributions for a time if your business is going through difficult times, which allows you to make better financial decisions during that time.

Why Do People Go for SEP IRAs? Advantages and Disadvantages

Many prefer going for a SEP IRA instead of a Roth IRA or a traditional IRA, and that’s because of the flexibility this retirement account offers people.

However, even if a SEP IRA is the best possible option for one person, it doesn’t mean it’s the same for you, so you need to study the advantages and disadvantages of this retirement plan if you want to go for one for your business.

These are some of the pros of getting a SEP IRA:


As we mentioned before, although there is a SEP IRA contribution deadline, this retirement plan gives you the freedom you don’t get with a Roth IRA or a traditional IRA. This doesn’t mean there are no SEP IRA contribution limits but that there are fewer than the ones you see in other IRAs.

The perfect example of this flexibility is how you can skip contributions for some time, which is something you can’t do when talking about traditional IRA contributions. Let’s say your business, as it happens with others, lies under a cyclical nature, and it’s not having a good time.

You, therefore, wouldn’t want to use the income you are getting for your own SEP-IRA since you need that money to cover up the losses you are having at the time. If you had a traditional IRA or Roth IRA, you would still have to make catch-up contributions to the account.

Nonetheless, you can skip employer contributions when you have a SEP IRA, and that allows you to plan better investments in the future. Investment choices are wider with this system, which includes mutual funds and individual stocks.

Easy Management

Managing and setting a SEP IRA is much simpler than managing ROTH IRAs or other retirement accounts. That makes them ideal for people who don’t want to stress out that much when investing in new things or without a financial expert helping them.

The reason for this is that there are not many things to administrate since you can make sizable employer contributions for other employees and yourself anytime you need it. Additionally, and this may be the best part of it all, tax filing isn’t required for this retirement account.

Having a SEP IRA is also beneficial for people who want to invest in other retirement plans since you can have a SEP IRA and a Roth IRA, for example. Managing SEP accounts is not difficult, so managing both accounts at the same time becomes less overwhelming, and that could bring you benefits in the long run.

SEP IRAs also allow you to terminate them at any time, and that means you can stop funding your retirement account once you terminate it. However, many still recommend people who don’t know a lot about making wise investment decisions hire a financial advisor to help them.

High Contribution Limits

Contribution limits are always something to be mindful of when managing Roth IRAs or any other retirement account. Having low contribution limits means you can’t get that much money into your retirement account yearly, which reduces your investment options a lot compared to accounts that allow you to make better investments.

SEP IRA contribution limits are way higher than the ones you have in a traditional IRA, and that makes it easier for everyone to invest in different assets and make various financial decisions when managing their retirement account.

While you only can get $6,000 in a traditional IRA yearly, SEP IRAs allow you to save $61,000 each year, and if you do the math, you are going to see that’s 10 times more than what you get in the former. Nonetheless, you can’t save more than 25% of your compensation.

The 25% compensation limit also applies to contributions for your eligible employees.

Regardless of that, your contributions are tax-deductible whether you are a small business owner or a self-employed individual. Tax deduction for self-employed individuals is 25% of their income, so they need to be aware of that to avoid making mistakes while reporting their taxes.

As we mentioned before, SEP IRAs also have some disadvantages for you to consider before applying for one, and you need to take them into account if you want to keep yourself from getting a retirement account that doesn’t fit your needs. Here are some cons of using a SEP IRA:

No Roth Version

You can’t have a SEP Roth IRA or something similar to that since this type of account doesn’t have a Roth version. Therefore, you can’t pay your distributions taxes before the time comes to have tax-free income when you retire.

Nonetheless, you can work around this since you can still have a Roth IRA and manage it at the same time you manage your SEP IRA. The issue with that is that you would be managing two retirement accounts, and that means working double or asking a financial expert to help you.

Proportional Contributions to Your Employees

One of the biggest issues of managing a SEP IRA is that employees can’t make contributions to the account, so everything relies on the employer and how he manages the account. However, there are some regulations and rules to follow when doing so.

This is when things get tricky since, although you can make contributions for yourself anytime you feel like it, you have to make a proportional contribution to all your eligible employees each time you make contributions for yourself.

Making a proportional contribution doesn’t become that big of a problem since SEP IRAs are for people with small businesses, so you could even have one eligible employee, but it’s still something to consider when thinking about creating a retirement account.

Regardless of that, since you can skip contributions, you can plan when to make some for yourself without having any issues with making proportional ones for your employees.

Early Withdrawal Penalties

Withdrawal penalties are an issue for almost all retirement accounts, and it’s odd to see a retirement IRA that doesn’t have any trouble with you taking your money out of it before you should. However, some exceptions allow you to make early withdrawals with no problem.

Unfortunately, there are few exceptions to avoid early withdrawal penalties when you have a SEP IRA, so you are most likely to go through the penalty if you want to make an early withdrawal. The penalty is 10% plus income taxes, so be aware of this if you think you will need to make an early withdrawal in the future.

We recommend you, though, avoid making early withdrawals unless you have an emergency that requires you to use those funds. Retirement accounts are to save money for when you retire, so using your retirement funds now loses the whole purpose of it.

You should also know that, although you can skip making contributions while you manage your account, SEP IRAs still need you to make the required minimum distributions of your retirement funds when you turn 72, and you need to get ready for that before getting to that age if you want to fully enjoy your retirement benefits.

Who Is Eligible for a SEP IRA?

who is eligible

If you are interested in getting a SEP IRA, you need to know who is eligible for this type of retirement account and if you qualify for it. As we mentioned before, this retirement account is meant for small business owners and self-employed people to use, so it wouldn’t suit you if you were the owner of a big company.

Freelancers, or anyone self-employed, don’t have to worry about eligible employees and making contributions for them since they don’t have employees at all. Things change when you are a small business owner.

When we say “small business owner,” we mean you have one or two employees working for you. If you do, you need to analyze if those employees meet the eligibility requirements or if they can’t get into a SEP IRA.

As we mentioned before, employees need to be 21 years old or older and have worked for you for at least three of the last five years. Therefore, employees you just hired or who are 18 years old wouldn’t be eligible for this retirement account. The last thing to consider is the compensation they got from you.

Eligible employees need to have earned $650 in 2021 from your business if you want them to get into a SEP retirement savings account. However, the IRS has a checklist for business owners to see if they are eligible for this account, so you can check it out to see if this account fits you.

How to Set Up a SEP IRA

The last thing to know is how to establish a SEP IRA, and doing it is not difficult at all. First, you need a written agreement that you want to get this retirement account. Most people use an IRS form such as the IRS Form 5305-SEP. Yet, you can do everything through an account provider.

Regardless of whether you want to fill out the form or follow the process with an account provider, you need to get an account provider to get a SEP IRA, so make sure to choose one of high quality.

While self-employed people and freelancers can skip this, small business owners need to explain everything related to what SEP IRAs are to their employees. You are good to go if you send them the IRS Form 5305-SEP we mentioned in this article.

Following up, you need to establish a SEP for each of your eligible employees with the help of your account provider. They will tell you everything you need to do afterward, but the process is finished as soon as you do that, so don’t worry about getting lost throughout it.

Related Reading:  Is the Vanguard SEP IRA Legit?

Bottom Line

  • As you could see, setting up a SEP is not as difficult as many people would think, and the only thing you need to do is get a decent account provider to help you take care of your eligible employees and the paperwork needed for the matter.

SEP IRAs have a good trade of pros and cons, so take some time to decide if you want to get one. Nevertheless, these accounts work better for freelancers and self-employed people since they don’t have to worry about proportional employee contributions.

Regardless of the retirement account you choose, it’s always a decent option to hire a financial expert to help you make the best financial moves possible for the account.

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Tim Schmidt


Tim Schmidt is an Entrepreneur who has covered retirement investing since 2012. He started IRA Investing to share his expertise in using his Self-Directed IRA for alternative investments. His views on retirement investing have been highlighted in USA Today, Business Insider, Tech Times, and more. He invested with Goldco.