SEP IRA: A Secret Goldmine for Small Business Owners

One of the complaints business owners sometimes have is that it can be difficult to save up an adequate nest egg given the annual contribution limits on a traditional IRA. For self-employed individuals or small business owners looking for a way to save for retirement and reap the benefits of a tax-advantaged account, a SEP IRA account can be a good choice.

Here’s what a SEP IRA is, how it works, and how to know whether it’s a good small business retirement plan for you.

What is a SEP IRA?

A Simplified Employee Pension plan is designed to make it easier to set up tax-advantaged retirement accounts for small business owners and their eligible employees. Contributions are set up to go into an IRA, which is how the term SEP IRA originated.

Any employer can set up a SEP plan — and that includes self-employed individuals. If you’re a small business owner or a self-employed person, including receiving money from business activities as a sole proprietor, you can set up a SEP IRA.

However, it’s important to realize that if you set up one of these accounts for yourself, you do also have to give all your employees the chance to participate.

Why small business owners like SEP IRAs

Small business owners (including me) like SEP IRAs because they come with a variety of advantages that make them simple to administer while providing an opportunity to build a bigger nest egg.

Here are some of the advantages of a SEP IRA:

• Lower eligibility requirements for contributors: You don’t need to meet as many stringent requirements to participate in a SEP IRA as you do with other types of accounts. The requirements are only that you need to have earned $750, be at least 21, and have worked for the business in at least three out of the past five years.
• Higher contribution limits: The traditional IRA limits you to $7,000 per year in contributions for 2024 (with $1,000 in catch-up contributions for those 50 and older). But with a SEP IRA, you can contribute up to $69,000 or 25% of compensation, whichever is less.
• Lower setup costs: With a SEP IRA, setup costs are often lower than if you set up different types of retirement plans for your employees.
• Employers can skip contributions if their business has a down year: When you have a tough year, you can suspend contributions to the retirement accounts if you have a SEP IRA.

It’s also possible to exclude some employees from SEP IRA participation, depending on the situation. For those covered by a union agreement, you might not need to make contributions. Additionally, if there are employees who don’t meet the minimum eligibility requirements, you don’t have to make contributions on their behalf.

How does a SEP IRA work?

A SEP IRA is a tax-deferred retirement account. You can potentially receive a tax deduction for contributions made today. The money then grows, and you pay taxes on it when you withdraw from the account during retirement.

The rules governing a SEP IRA are similar to those for a traditional IRA. You have to wait until you’re 59 1/2 to access the money without penalty, and you pay taxes when the money is distributed. Additionally, SEP IRAs are subject to required minimum distributions when you reach age 72.

As a small business owner or self-employed person, you can make contributions to your SEP IRA, but you also need to make contributions to any eligible employee accounts as well. That’s the main issue to be aware of when setting up a SEP IRA — if you hire people later, you will need to make contributions to their accounts as well as to your own.

Employee contributions must be made in the same proportion as the contributions you make to your own account. As an owner, if you contribute 10% of your salary to a SEP IRA, your employer contributions to your employee SEP accounts must be 10% of their earnings.

Plus, any contribution you make to an employee SEP is immediately 100% vested, which means you can’t make rules about how long they have to wait before those employer contributions are fully theirs. Some employer contributions to accounts like 401(k)s might not be immediately vested, which means employees can’t roll them over or take them elsewhere until they meet the vesting requirements. Employer contributions to an employee SEP account are entirely vested and the employee has immediate access.

Finally, you can roll over funds from other accounts to your SEP, including a 401(k) or from a traditional IRA. Just realize there is no Roth version of a SEP, so you should double-check the tax consequences of rolling over from a Roth 401(k) or Roth IRA before you make the move.

How investing with a SEP IRA works

When investing with a SEP, you can choose from different investment choices available through your custodian. In many cases, SEP IRAs include choices like stock and bond funds. If you want to learn how to invest money in real estate investment trusts, some SEPs also include these. For example, I have a SEP IRA with Acorns. Because Acorns is a robo-advisor, it creates my portfolio based on my time frame and risk tolerance, and use a mix of stock and bond ETFs, as well as REITs.

It’s also possible to set up a self-directed SEP IRA, in which the investment choices go beyond basic market asset classes. However, in order to set up a self-directed SEP IRA, it makes sense to work with a custodian that specializes in alternative investments and understands which assets can be held in an IRA — and any rules that limit how those assets are used.

When setting up a SEP IRA, your employees should have access to a portal that allows them to choose from available assets, as well as set up automatic plans that automatically allocate contributions according to their preferences.

How SEP IRA distributions work

As with traditional IRAs, SEP accounts come with a 10% penalty if you take money out before you turn age 59 1/2. When you withdraw the money, you designate that it’s a distribution, and you need to be prepared to pay taxes on the money. There are exceptions to paying the 10% penalty on SEP IRAs, but they are specific, and you need to double-check before withdrawing the money.

Your SEP IRA distribution will not be subject to the 10% penalty in the following circumstances:

• Death of the IRA owner
• Permanent disability
• Qualified higher-education expenses
• The use of up to $10,000 for a down payment as a first-time homebuyer
• Certain medical expenses

Your distribution will still be counted as ordinary income and taxed accordingly, regardless of whether you pay the penalty. SEP IRAs are also subject to RMDs when you reach age 72, so you must begin withdrawing money at that point.

One thing to keep in mind when you’re doing your retirement planning is that there is no provision to take loans against your SEP IRA. Although some people might like to have the option at some point to use a 401(k) to pay off debt, SEP accounts don’t allow you to do something like that.

SEP IRA contribution limits

The IRS determines the contribution limits for the upcoming year based on expected cost-of-living increases and other factors. For the tax year 2024, the contribution limit on a SEP IRA is up to $69,000 or 25% of compensation, whichever is less.

In general, it’s possible to make contributions until tax day. So for 2024, you have until the tax filing deadline in 2025 to make a contribution. 

Contributing to traditional and Roth IRA accounts

It’s also possible to contribute to separate traditional and Roth IRA accounts if you’re eligible. Your contributions to a SEP IRA won’t count against your contribution to other accounts. So if you meet the criteria for contributing to a Roth IRA, you could max out those contributions, while at the same time maxing out SEP account contributions.

You may consider consulting with a tax advisor and/or financial advisor before claiming deductions for both your SEP and traditional IRA contributions. There are some limitations to how much you can deduct when you have an employer account, such as a SEP IRA, as well as an individual account.

Quick view: SEP IRA pros and cons

Pros	Cons
Higher contribution than a traditional IRA	There are no catch-up contributions like with traditional IRAs
Easy to set up and administer	SEP IRAs don’t come with Roth versions
Tax-deductible contributions	You have to make contributions to employee accounts if you make contributions to your own SEP account
Flexible contribution schedule — you don’t have to contribute every year	You have to take RMDs
You can still make contributions to a Roth or traditional IRA if you qualify	The early withdrawal penalty of 10% applies

Bottom line

As someone managing either self-employment or a small business, one of the costly retirement mistakes you can make is not planning for your future with a tax-advantaged retirement account. However, you might be discouraged by the relatively small amount of money you can set aside in a traditional or Roth IRA.

If you’re hoping to boost your nest egg, you can do so by opening a SEP IRA. For the self-employed, many online platforms — including Betterment, Wealthsimple, and Acorns — have investment options that include SEP IRA plans. You can also open SEP IRAs for you and your employees with more traditional brokers like TD Ameritrade, Fidelity, and others.

By understanding how a SEP IRA might fit into your long-term retirement planning, you could set aside more tax-advantaged dollars for your future, boosting your ability to reach financial independence and meet your personal lifestyle goals. Consider speaking with a financial professional about your choices so you can set up an account that allows you to make the most of your money.