“SEP IRA” is the abbreviation for “simplified employee pension individual retirement account.” Unfortunately, that doesn’t offer much clarity for many people. If you are a business owner, however, it’s worth taking a deeper dive and learning more about this retirement planning tool.
Just because you aren’t someone else’s employee doesn’t mean you can’t have a retirement account. A SEP IRA is much like a traditional individual retirement account (IRA), but it is designed for business owners. Contributions that you make now, while you are operating your business, are tax-deductible, lowering your current tax burden. Then those contributions grow tax-deferred until you retire.
At that point, distributions are taxed as income. Since you will likely be in a lower tax bracket after you retire than you were when you were working, you will probably pay less in income tax on that money. As with traditional IRAs, after a certain age (73 in 2023), you must take the required minimum distributions (RMDs).
What Are SEP IRA Contribution Limits?
If contributing to a simplified employee pension sounds like a good idea to you, you will need to figure out how to maximize your contributions. You are probably aware that traditional IRAs have contribution limits (in 2023, that’s $6,500 for individuals under 50; those over 50 can contribute $7,500).
However, you can contribute much more to a SEP IRA—possibly about ten times more! The contribution limit cannot exceed the lesser of either:
- 25% of compensation or
- $66,000 (in 2023)
For instance, if you are a small business owner who receives $300,000 in compensation in 2023, you can contribute up to $66,000 (since 25% of your compensation is $75,000). If your compensation is $120,000, you can contribute up to $30,000, which is 25% of your compensation.
Unlike a traditional IRA, which allows that extra $1,000 “catch up” contribution for those over 50, there is no “catch up” increase in contribution limits for older business owners with a SEP IRA.
Who Should Have a SEP IRA?
SEP IRAs are usually best for individuals who are self-employed or who own a business with very few employees or none at all. If the IRS considers your employees eligible participants in your plan, you must contribute on their behalf. Furthermore, the contribution needs to be the same percentage of compensation that it is for you. In other words, if you are contributing 25% of your compensation to your own employee pension, you must contribute 25% of your eligible employees’ contribution to their SEP IRAs. As the business owner, you are responsible for making contributions to your employees’ accounts, but each employee owns their own account and has control over it.
Which employees are considered “eligible participants?” Those who are over 21 years of age, have worked for you in at least three of the past five years, and have earned a certain minimum amount in each of those years (the minimum for 2023 is $750).
So if you own a shop with six adult employees who each earn $40,000 per year, and you contribute 25% of your own compensation to your employee pension, you would be obligated to contribute $10,000 per year (25% of their compensation) to an employee pension for each of them. That could be more costly than you are comfortable with.
However, if you are self-employed, or your employees aren’t considered eligible participants under IRS rules, a simplified employee pension offers an opportunity to accumulate significant retirement savings that can grow tax-free until you begin taking contributions in retirement.
Pros and Cons
As mentioned above, a SEP IRA allows you to contribute much more to your retirement account than a traditional IRA or a Roth IRA. Another advantage is that a simplified employee pension plan is easy to set up and operate, and the administrative costs of a plan are relatively low; that’s important to many small business owners. Also, contributions to the account are flexible, varying with your annual compensation. If the cash flow in your business is not consistent from year to year, that flexibility is important.
Unlike a 401(k), owners of a simplified employee pension cannot take a loan against their account, and cannot use assets in the account as collateral for a loan. You can make early withdrawals from a SEP IRA, but those withdrawals are taxed as income before age 59 ½ and carry an additional 10% tax penalty. For employees, the inability to make their own contributions may be a downside to these plans.
While you can’t make “catch-up” contributions to a SEP IRA, the fact that regular contributions can exceed traditional IRA contribution limits generally offsets that disadvantage.