SEP IRA: What It Is and Why It Matters

Definition

A Simplified Employee Pension (SEP) IRA is a retirement plan that an employer or self-employed individual can establish. The employer makes tax-deductible contributions on behalf of eligible employees, including the business owner, to a traditional IRA.

How It Works

A SEP IRA allows employers to make contributions for their employees' retirement. It is particularly popular with self-employed individuals and small-business owners because of its high contribution limits and low administrative burden. Only the employer can contribute to a SEP IRA; employees are not permitted to make their own contributions to the plan.

Contributions are made to a traditional IRA, meaning they are tax-deductible for the employer, and the investments grow tax-deferred until retirement. Withdrawals in retirement are taxed as ordinary income.

One of the key features of a SEP IRA is the flexibility in contributions. The employer can decide each year whether to contribute and how much to contribute, from 0% up to the legal limit. However, if a contribution is made for any employee, it must be made for all eligible employees at the same percentage of their compensation.

To establish a SEP IRA, the employer typically completes a simple form, such as the IRS Form 5305-SEP, and provides it to a financial institution that will act as the custodian for the accounts.

Key Rules and Limits

• Contribution Limit: For 2026, the maximum contribution is the lesser of 25% of the employee's compensation or $72,000.
• Compensation Cap: The maximum amount of compensation that can be considered for calculating contributions in 2026 is $360,000.
• Contribution Deadline: Contributions for a tax year can be made up until the due date of the business's tax return for that year, including extensions. For example, 2026 contributions can be made until the tax filing deadline in 2027.
• Eligibility: An employer must include any employee who is at least 21 years old, has worked for the employer in at least three of the last five years, and has received at least $800 in compensation for 2026. Employers can use less restrictive eligibility requirements.
• Vesting: All contributions are immediately 100% vested, meaning the employee owns the funds as soon as they are contributed.
• Withdrawals: Withdrawals follow the same rules as traditional IRAs. They are taxed as ordinary income, and a 10% penalty may apply to withdrawals before age 59½. Required Minimum Distributions (RMDs) must begin at age 73.

Example

Let's say a self-employed graphic designer has a net adjusted self-employment income of $100,000 in 2026. The contribution is calculated as 20% of the net adjusted self-employment income, which is a simplified way to account for the deductibility of the contribution itself. In this case, the designer could contribute $20,000 to their SEP IRA for the year.

If that same graphic designer had an employee who earned $40,000 in 2026 and met the eligibility requirements, the designer would also have to contribute the same percentage of the employee's salary to their SEP IRA. So, if the designer contributed 20% for themselves, they would also need to contribute 20% of the employee's $40,000 salary, which is $8,000, to the employee's SEP IRA.

Pros and Cons

Pros

• High Contribution Limits: The contribution limits for SEP IRAs are significantly higher than those for traditional and Roth IRAs.
• Flexibility: Employers can choose to contribute in some years and not in others, depending on the business's financial performance.
• Easy to Set Up and Administer: SEP IRAs have minimal paperwork and no annual filing requirements for the employer.
• Tax Deductible Contributions: Contributions are tax-deductible for the business.

Cons

• Employer Contributions Only: Employees cannot contribute to their SEP IRAs.
• Equal Contribution Rate: The requirement to contribute the same percentage of compensation for all eligible employees can be costly for businesses with multiple employees.
• No Catch-Up Contributions: Unlike 401(k)s and traditional IRAs, there are no catch-up contributions for individuals age 50 and over.
• No Roth Option (Generally): While the SECURE 2.0 Act introduced the possibility of Roth SEP IRAs, it is not yet widely available.

Common Mistakes to Avoid

• Incorrectly Calculating Contributions: For the self-employed, the contribution is based on net adjusted self-employment income, not gross income. For employees, using the wrong definition of compensation can lead to errors.
• Failing to Contribute for All Eligible Employees: If a contribution is made for the business owner, it must also be made for all eligible employees at the same percentage.
• Missing the Contribution Deadline: Contributions must be made by the tax filing deadline, including extensions, for the year they are intended for.
• Rollover Errors: When moving funds, it's crucial to follow IRS rules to avoid taxes and penalties. A direct trustee-to-trustee transfer is generally safer than an indirect rollover where you receive a check.

Frequently Asked Questions

Q: Can I contribute to both a SEP IRA and a traditional or Roth IRA?

A: Yes, you can contribute to both a SEP IRA and a traditional or Roth IRA in the same year, subject to the respective contribution limits and income limitations for each type of account.

Q: What is the difference between a SEP IRA and a Solo 401(k)?

A: A Solo 401(k) is only for self-employed individuals with no employees (other than a spouse). It allows for both employee and employer contributions, which can result in a higher total contribution at certain income levels compared to a SEP IRA. Solo 401(k)s may also offer features like loan provisions and a Roth contribution option, which are not typically available with SEP IRAs.

Q: What happens if I contribute more than the annual limit to a SEP IRA?

A: Excess contributions are subject to a penalty tax if not corrected in a timely manner. The excess amount, plus any earnings on it, should be withdrawn from the account.

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This article reflects 2026 rules and limits. Tax laws and financial regulations change — consult a qualified financial advisor or visit IRS.gov for the latest information.