SEP IRAs: What are they, and how do they work?

In the realm of retirement planning, the simplified employee pension individual retirement account (SEP IRA) carves out a niche for itself as an uncomplicated yet rewarding option; but what exactly does a SEP IRA entail, and how does it fit into your overall financial landscape?

What is a SEP IRA, and how exactly does it work?

SEP IRAs operate similarly to traditional IRAs in that contributions are tax-deferred, meaning you use pre-tax dollars (and take a deduction) to fund the account and pay taxes when you make a withdrawal. SEP IRA investments can also grow tax-deferred until retirement, at which point withdrawals are also taxed as ordinary income.

Employers of any size can establish a SEP IRA retirement plan, but it is often best suited for small businesses with few employees and those who are self-employed—as all IRS-deemed eligible employees are required to participate (more on that later).

SEP IRA contribution limits

As of 2023, a traditional IRA allows contributions up to $6,500 ($7,500 for individuals aged 50 and older). In contrast, SEP IRAs allow contributions of up to 25% of your compensation or $66,000 (whichever is less): nearly ten times traditional IRA limits.

Contributions are not required on a regular basis but are instead due on the same date as your federal income tax return deadline. Thus, for the 2023 contribution year, your deadline would be April 18, 2024.

Who is eligible for a SEP IRA?

Only those who operate as a sole proprietor or business owner, are in a partnership, or earn self-employment income by providing a service can open a SEP IRA—with this as the only requirement.

While exceptions for SEP IRAs do exist, eligibility typically extends to employees who are over the age of 20, have worked for a given employer for at least three out of the past five years, and earn at least $750 in annual income (as of 2023).

SEP IRA pros and cons

As with any retirement plan, SEP IRAs come with their own set of advantages and disadvantages.

Pros

●      High Contribution Limits: SEP IRAs have much loftier contribution limits than both traditional and Roth IRAs.

●      Tax Benefits: Contributions are tax-deductible, and investments grow tax-deferred.

●      Simplicity: SEP IRAs are relatively easy to set up and maintain.

●      Flexibility: Employers can decide each year how much they want to contribute, providing flexibility during periods when business income might fluctuate.

Cons

●      A Lack of Catch-Up Contributions: Unlike other retirement plans, SEP IRAs do not allow catch-up contributions for those aged 50 and above.

●      Mandatory Employee Contributions: Business owners with employees who decide to contribute to their own SEP IRA are also obligated to contribute to that of their employees—with an amount reflecting equal compensation for everyone. For example, if you choose to contribute 5% of your salary to your SEP IRA, you must also contribute 5% of each eligible employee’s salary to their respective SEP IRA.

●      Withdrawal Penalties: As with traditional IRAs, early withdrawals taken from a SEP IRA prior to age 59½ may incur a 10% penalty.

●      A Lack of Participant Loans: You are not permitted to borrow against your SEP IRA.

SEP IRA vs. Roth IRA and 401(k)

SEP IRAs, Roth IRAs, and 401(k) plans each offer unique advantages and limitations that can serve different purposes depending on your own unique financial situation and retirement goals. Here's a more detailed comparison:

SEP IRA vs. Roth IRA

With respect to tax treatment, SEP IRAs and Roth IRAs sit at opposite ends of the spectrum. SEP IRA contributions are made with pre-tax dollars, meaning they're tax-deductible in the year you make them: reducing your current taxable income. However, withdrawals made during retirement are taxed as ordinary income.

On the other hand, Roth IRA contributions are made with after-tax dollars. While you won’t enjoy a tax deduction when you contribute, your money grows tax-free (with qualified withdrawals in retirement also tax-free). This is particularly beneficial if you expect to occupy a higher tax bracket during retirement.

Furthermore, SEP IRAs have higher contribution limits compared to Roth IRAs. In 2023, business owners can contribute up to 25% of their compensation (or $66,000) to a SEP IRA, while the Roth IRA limit is only $6,000 (or $7,000 if you're age 50 or older).

SEP IRA vs. 401(k)

Both SEP IRAs and 401(k)s are employer-sponsored retirement plans, but they differ with respect to administration and contribution rules. SEP IRAs are simpler and less costly to administer than 401(k) plans, making them an attractive option for small businesses and self-employed individuals.

In contrast to a 401(k) plan wherein both the employee and employer can contribute, employers are the sole contributors to a SEP IRA. 401(k) plans also often allow employees to take loans against their account balance, a feature not available with SEP IRAs.

Multiple retirement account management with SEP IRAs

Planning for retirement often involves juggling different types of retirement accounts such as a SEP IRA, traditional IRA, Roth IRA, and 401(k). Let’s dive into the possibilities and restrictions involved with contributing to multiple retirement accounts simultaneously.

Can you contribute to a SEP IRA and traditional/Roth IRA concurrently?

Yes, you can contribute to a SEP IRA and traditional or Roth IRA at the same time (per separate contribution limits). For 2023, you can contribute 25% of your compensation or $61,000—whichever is lower—to a SEP IRA and up to $6,000 ($7,000 if you're age 50 or older) to a traditional or Roth IRA.

However, keep in mind that if you or your spouse is covered by a retirement plan at work (such as a SEP IRA), this may affect the deductibility of traditional IRA contributions. Roth IRA contributions, on the other hand, are not tax-deductible; but income limits do exist that can affect your ability to contribute.

Can you contribute to both a 401(k) and SEP IRA?

Yes, you can contribute to both a 401(k) and SEP IRA—but there are some caveats. You can contribute to both plans if you’re self-employed with no employees, but those with employees who contribute to a SEP IRA must also contribute to their SEP IRAs.

Employees who also have self-employment income, meanwhile, can contribute to their employer's 401(k) as well as their own SEP IRA. However, the total contribution amount for all of these plans currently maxes out at $61,000 (for 2023).

Can you open a SEP IRA and fund it for the previous year?

Yes, this is in fact possible. You can even set up and fund a SEP IRA for a given tax year after the calendar year has ended.

For example, it’s possible to establish and make contributions to a SEP IRA for the 2023 tax year as late as the due date (including extensions) of your 2023 income tax return in 2024. This gives business owners more time to fund the account than they have for other retirement account types.

Bottom Line: SEP IRAs

SEP IRAs are often a vital tool for retirement planning as they offer numerous benefits including high contribution limits and tax-deductible contributions. However, they also come with some drawbacks such as early withdrawal penalties and the need for employers to contribute an equal percentage to all eligible employees' SEP IRAs if they do so for their own.

Notably, if your income fluctuates from year to year (as seen among self-employed individuals and/or small business owners), SEP IRAs are sometimes particularly beneficial as yearly contributions are not required. Due to the equal contribution requirement, they are also often better suited for those with few or no employees.

Still have questions about SEP IRAs? Schedule a FREE Discovery call with one of our financial advisors today.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.