What is a Simplified Employee Pension (SEP) IRA?

A SEP IRA is kind of like having separate piggy banks for you and each of your employees…

Only you can contribute to the piggy banks, and you must give everyone the same percentage of their income. But your employees get to decide how to invest the money in their piggy bank, and they can break it open when they retire.

SEP IRAs are designed for self-employed or freelance workers who don’t have access to an employer-sponsored retirement plan such as a 401(k). A SEP IRA allows self-employed people and small-business owners to make tax-deductible contributions to a retirement account at a higher annual maximum than a traditional IRA.

For employees to be eligible for the employer’s SEP IRA plan, they must be at least 21 years of age, have worked at the company for at least three of the last five years, and have made at least $750 in compensation during the year. Employers aren’t allowed to impose more stringent regulations for employee eligibility, but they can ease restrictions by allowing employees to enroll immediately after they start work.

Employers don’t have to contribute to their employees’ SEP IRA accounts every year. In years when the business is slow, business owners can choose not to make SEP IRA contributions. But they must contribute to the accounts of everyone at the company at the same rate. So if they aren’t contributing to their employees’ accounts, they must also forgo adding to their own account.

For most SEP IRAs, employees can’t contribute to their own accounts. However, some plans allow employees to make traditional IRA contributions to their SEP IRAs, with an annual contribution limit of $6,000 for 2022 (increasing to $6,500 in 2023).

The process of opening a SEP IRA account is simple. The hardest part is choosing the right IRA provider for you. One thing to consider when choosing a provider is how hands-on you want to be with your investments. With a traditional IRA broker, you can decide where to invest your money. For some people, that might be a perk. But if the idea of having to make investment decisions seems overwhelming, a robo-advisor that can choose your investments might be the right choice.

Also, be sure to consider the fees that come with the account. One of the benefits of a SEP plan is that costs tend to be comparatively low, so it’s worth doing your homework on the fees providers charge.

Once you’ve chosen the right provider, you’ll have to fill out a formal written agreement such as a 5306-SEP form. Depending on the broker you select, they might submit this form for you. If you have employees, be sure to provide them with the necessary information to set up their accounts so that you can make contributions. You don’t file the form with the IRS. Instead, the employer keeps it for their own records.

Once you’ve decided that a SEP IRA is right for you and have opened an account with the provider of your choice, it’s time to start investing that money. This part is crucial because if you don’t invest, you’ll just have a no-interest savings account with fees.

The process for investing your SEP IRA will vary depending on your provider. If you opened your IRA at a bank, you’d probably be limited to investing in Certificates of Deposit, which have a comparatively low rate of return. If you opened your IRA with a brokerage firm, you’d likely have the opportunity to invest your SEP IRA in a wide variety of securities.

Your investment strategy will largely depend on your tolerance for risk and how many years you have until retirement. If you don’t have much appetite for risk or many years left before you retire, you might want to consider a lower-risk investment like bonds. If you have a high risk tolerance or have many years until retirement, you might feel comfortable being more adventurous and investing in the stock market.

As with any financial decision, there are advantages and disadvantages to choosing a SEP IRA to save for retirement. Let’s cover the most significant pros and cons of these plans.

Pros of a SEP IRA

Perhaps the biggest perk of SEP IRA plans is the higher contribution limit. For 2022, you can only contribute up to $6,000 per year with a traditional IRA, and you can put up to $20,500 into a 401(k). The contribution limits for SEP IRA plans far exceed the other plans: either 25% of your annual compensation or $61,000, whichever is less.

SEP IRA plans are also easy to set up and tend to have low administrative fees, making them ideal for very small businesses who want to reward their employees, but don’t want the administrative costs associated with a traditional 401(k) plan.

Another characteristic of SEP IRA plans is flexibility in how much you can contribute. You don’t have to lock yourself into commiting to a particular percentage year after year. Instead, you can reward your employees with a more substantial contribution in years when business is good, while containing costs by decreasing contributions in years when business is slow.

Finally, employees get to make their own investment decisions with a SEP IRA. This factor is beneficial for the employer, who can fund the account without having to make investment decisions on behalf of their employees. It’s also helpful for the employees, who can take control of their investments.

Cons of a SEP IRA

The biggest drawback for employers when it comes to a SEP IRA plan is that you have to contribute to everyone’s retirement account at the same rate. You can’t contribute to your own IRA at a higher percentage of compensation than you contribute to your employees’ accounts. Obviously, this requirement doesn’t affect self-employed people with no employees.

The other downside to SEP IRA plans is that there is no so-called “Roth” option, as there is with 401(k) and other IRAs plans, which involves contributing after-tax money and then being able to withdraw money tax-free after retirement. With a SEP IRA, the contributions are pre-tax, meaning you’re getting the tax benefit on the front end. However, you can still invest separately in a Roth IRA, and thus get the tax benefit on the back end, even if you have a SEP IRA.

One of the reasons that SEP IRAs are so beneficial to small-business owners is that the contribution limit is significantly higher than other types of IRAs. In 2022, you can contribute up to 25% of your net earnings, with a maximum contribution limit of $61,000. This number will increase in 2023 to $66,000.

Remember, though, whatever percentage you contribute to your own SEP IRA as a small business owner, you must also contribute to the SEP IRAs of your employees. If you add 25% of your income to your SEP IRA account, you must also add an amount equal to 25% of your employee’s salary to their SEP IRA account.

Outside of the contribution limit, SEP IRAs mostly look and act like traditional IRA plans. You can begin to withdraw from your SEP IRA at age 59 1/2. Taking money out of the account earlier than that could result in an early withdrawal penalty. You’re not required to start withdrawing at age 59 1/2 — if you prefer, you can leave the account untouched for another decade. At the age of 73, you have to start withdrawing required minimum distributions or risk paying a sizeable tax to the IRS.

Robinhood does not provide tax advice. For specific questions, you should consult a tax professional.