What is a SEP IRA and how does it work?

Traveling the world, spending time with loved ones and pursuing new hobbies are common retirement dreams. And the right savings strategy could help turn these dreams into reality. But what happens if you can’t access traditional retirement plans—like an employer-sponsored 401(k)? 

That’s where a simplified employee pension individual retirement account (SEP IRA) comes into play. The SEP IRA was designed to help self-employed workers and small business owners save for their financial futures. 

Learn what a SEP IRA is, how it works and how it compares to other retirement plans.

Key takeaways

• SEP IRAs are common retirement plans for self-employed individuals, small business owners and contractors.
• SEP IRAs typically have higher contribution limits than standard IRAs.
• SEP IRAs are funded with employer contributions. Employers must contribute the same percentage of income to each eligible employee’s SEP IRA.
• Traditional SEP IRAs are taxed upon withdrawal, but SEP Roth IRAs are taxed when contributions are made. 

A SEP IRA is a tax-advantaged retirement plan designed for business owners, contractors and self-employed workers. It shares some similarities with standard IRAs. But SEP IRAs may have higher contribution limits and different eligibility requirements. 

In 2023, traditional IRAs and Roth IRAs have a $6,500 contribution limit. Account holders 50 and over can make an additional $1,000 catch-up contribution. 

For the same year, SEP IRA participants could invest the lesser of $66,000 or up to 25% of the first $330,000 they earn. Traditional IRA and Roth IRA contributions are made by the account holder. But SEP IRAs are funded with employer-only contributions. 

Traditional SEP IRA contributions are made with pretax dollars and experience tax-deferred growth. Once the account holder reaches retirement age, their withdrawals will be taxed as regular income.

As part of the SECURE 2.0 Act of 2022, SEP IRA participants will have the choice of a Roth option beginning in 2023. Unlike traditional SEP IRAs, SEP Roth IRAs are funded with after-tax dollars, so withdrawals made after age 59½ won’t be taxed. 

Wondering if a SEP IRA is right for you? Here are a few key things to consider:

SEP IRA rules

The IRS applies some of the same rules to IRAs and SEP IRAs. Both types of accounts: 

• Fund traditional plans with tax-deductible contributions
• May impose a 10% tax penalty on withdrawals made before age 59½ 
• Have required minimum distributions (RMDs) for traditional plans

Keep in mind that RMDs typically start at age 72. But Roth IRAs and SEP Roth IRAs don’t impose RMDs. 

Unlike standard IRAs, SEP IRAs:

• Are funded with employer-only contributions
• Have different eligibility requirements
• Require employers to contribute the same percentage of income to each eligible employee’s account

SEP IRA eligibility

Having other retirement accounts—like a 401(k) or traditional IRA—won’t necessarily prevent someone from being able to use a SEP IRA. But SEP IRAs have specific eligibility requirements. 

Employees typically need to:

• Be at least 21 years old
• Have worked for the business in any three of the last five years
• Meet the minimum income requirements outlined by the IRS

SEP IRAs require employers to contribute the same percentage of income to each eligible employee’s account. That’s one reason why SEP IRAs may be a better fit for self-employed individuals or those with few employees than for larger businesses. 

The IRS places limits on the amount of money a person can contribute to certain retirement accounts each year. The maximum annual contributions for SEP IRAs tend to be higher than the limits for traditional IRAs and Roth IRAs. 

For 2023, SEP IRA contribution limits are the lesser of:

• $66,000, or
• Up to 25% of the first $330,000 earned

Who contributes to a SEP IRA?

Only an employer can contribute to a SEP IRA plan. Contributions are based on a percentage of each eligible employee’s earnings. And employees are fully vested in their accounts—meaning they own the account and the funds in it.

Employers can typically set up a SEP IRA using IRS Form 5305-SEP. Instead of submitting the form directly to the IRS, an employer could complete a SEP filing document through a qualified financial institution, mutual fund or insurance company.

The setup process typically involves:

1. Comparing SEP IRA providers, plan requirements, fees, investment options and more
2. Completing IRS Form 5305-SEP or signing up through a participating broker
3. Setting up accounts for eligible employees
4. Providing qualified employees with the plan information
5. Making contributions

Depending on the SEP IRA plan provider, account holders may have a variety of investment options—like mutual funds, stocks, bonds and more. As of 2023, SEP IRA participants may also choose either the traditional or Roth option. Consulting a professional tax adviser could help eligible participants decide which plan is right for them. 

SEP IRAs could help self-employed workers and small business owners save for retirement. But there are some things to consider before opening this type of account:

Potential benefits of a SEP IRA

A SEP IRA:

• Could help self-employed workers save for retirement
• Has a relatively simple setup process
• Uses tax-deductible contributions for traditional plans
• Offers a Roth option
• May have higher contribution limits than some other retirement plans

Possible drawbacks of a SEP IRA

SEP IRAs: 

• Are only funded with employer contributions
• Require that employers treat each employee’s contributions the same
• May not allow catch-up contributions for those 50 and over

In addition to SEP IRAs, self-employed workers and business owners may be eligible for other retirement savings accounts—like solo 401(k)s and SIMPLE IRAs. 

Here’s how a SEP IRA stacks up to other common retirement plans: 

Self-employed workers, small business owners and even freelancers may be eligible for a SEP IRA. This retirement savings account may have higher contribution limits than standard IRA options. 

It also offers some potential tax benefits. Traditional SEP IRA contributions are tax deductible and experience tax-deferred growth. The newly established SEP Roth IRA is funded with after-tax dollars, so qualifying withdrawals aren’t taxed. 

Want to learn about more ways to save for the future? Read how employee stock ownership plans (ESOPs) could be part of saving for retirement.