Man using laptop to sign up for a SEP IRA
Bernardbodo/Adobe Stock

More than 15 million people in the United States are self-employed, according to a 2019 report from FreshBooks. For many of these workers, planning for retirement has its own quirks and challenges. They can’t rely on a company and the modest contribution limit for a Traditional or Roth IRA just isn’t going to cut it.

Rather than run the risk of having a lower standard of living in retirement, self-employed workers do have another savings option to help boost the size of their retirement nest egg — the SEP IRA. With higher contribution rates and a degree of flexibility, the SEP IRA might be the retirement plan many self-employed workers are looking for.

What is a SEP IRA?

A SEP IRA, or Simplified Employee Pension Individual Retirement Arrangement, has many features similar to a traditional IRA, but comes with a few extra perks that make it especially desirable for those without an employer-sponsored plan. A SEP IRA is a tax-deferred retirement plan for anyone who is self-employed, owns a business, employs others, or earns freelance income, according to Vanguard. SEP IRA contributions are considered employer contributions, so the business makes them to the employee (you).

The SEP IRA is designed for simplicity — especially if you own your own business and don’t hire other employees.

SEP IRA basics:

  • Make tax-deductible retirement contributions as a self-employed person
  • Contribute the lesser of 25 percent of your income or $56,000 for 2019
  • Easy to open with an account provider
  • No Roth option
  • Must contribute an equal percentage of compensation for any employees

How does a SEP IRA work?

First of all, rather than limiting your annual IRA contributions to $6,000 — the maximum that workers under age 50 can contribute to Traditional and Roth plans in 2019 — SEP IRA’s allow you to contribute up to the lesser of 25 percent of your compensation or $56,000. For some workers who double as their own bosses, this also provides an opportunity to set aside more than they could in an employer’s 401(k), which caps 2019 contributions at $19,000.

Because the SEP is a traditional IRA, it’s subject to “the same investment, distribution and rollover rules” as traditional IRAs, according to the IRS. While you can take distributions from your SEP IRA at any time, the IRS says, any withdrawals before the age of 59 ½ will be included in your taxable income and may be subject to a 10 percent tax penalty. Additionally, the IRS requires you to take required minimum distributions in the year you turn age 70 ½, just as you would with a Traditional IRA.

You’re eligible to contribute if you’re self-employed — even if you have other retirement accounts. If your business is a side hustle and you still have a regular employer, you can open a separate SEP IRA and contribute, while still socking money away in a 401(k). Plus, if you want a little tax diversity, a SEP IRA is different from a Roth IRA, so you can contribute to both accounts.

“For the self-employed individual, [a SEP IRA is] really an easy and cost-effective way to save a decent-sized chunk of money into a retirement plan,” says Tim Steffen, director of advanced planning at Baird.

Realize, though, that if you end up hiring people, you need to treat them the same as you. Qualified workers who need to receive the same percentage from your employer contribution as you do include those who:

  • Are at least 21 years old
  • Earn more than $600 annually
  • Have worked in your business three out of the last five years

Keep that in mind as you move forward. If you contribute a large percentage of your earnings to a SEP IRA, you’ll have to contribute that same percentage of your employees’ income to their own retirement accounts. So consider your future plans. For some business owners, a SIMPLE IRA might offer a better solution.

Advantages of a SEP IRA

  • Provides a way for you to save for retirement: If you’re self-employed, you might not have many options for tax-advantaged retirement savings, and this can help.
  • Tax-deferred: Your contributions are made with pre-tax dollars, so you receive a tax deduction today and only pay taxes when you withdraw.
  • Easy to set up: A broker offering SEP IRAs can guide you through a few simple steps after you fill out one IRS form.
  • Make bigger contributions: Contribution limits are higher than Traditional and Roth IRAs, as well as more than what you can contribute to a 401(k).
  • Flexibility: You don’t have to make a contribution every year (for yourself or your employees).

Disadvantages of a SEP IRA

  • Employees must be treated the same as you: This is an employer-only contribution. Employees don’t make their own contributions and you must contribute the same percentage of employee compensation as yours.
  • No catch-up contributions: If you’re over the age of 50, there are no catch-up contributions like you see with IRAs and 401(k)s. (However, the higher contribution limits of a SEP IRA might outweigh this negative.)
  • No Roth option: Those who prefer socking away money with after-tax contributions and enjoying tax-free withdrawals are out of luck. There is no Roth option, so while your money will grow tax-free, you will still be on the hook for taxes when you take distributions. You’ll also be subject to required minimum distributions later.

Getting started: Opening a SEP IRA

Setting up a SEP IRA is simple. Start by filling out and filing IRA form 5305-SEP. Rather than sending the form to the IRS on your own, you can use a broker like Fidelity or Vanguard to sign up and provide the form for you.

Compare SEP IRA custodians, before making your choice, though. Review minimum investments, fees and investment options offered. Find out how employees can access their accounts as well, should you choose to add employees.

How to invest with a SEP IRA

Remember: your SEP IRA is a type of retirement account, not an actual investment. As with any investment account, how aggressively you invest and the types of assets you buy depends on your age, the age at which you plan to retire and your risk tolerance. Carefully consider your own future needs as you choose investments for your portfolio.

In general, asset allocation models suggest that you weight your retirement portfolio toward stocks while you’re young and further away from retirement. As you move closer to your retirement date, many experts suggest reducing the risk of your portfolio and boosting its income component by rebalancing to include more bonds. The reason? Stocks historically have generated bigger returns over the long-term than fixed-income assets, but suffer more price volatility in the short-term.

Your account provider should have a variety of stocks, bonds and mutual funds to choose from. Each of your employees should have their own accounts with the provider so they can choose their own investments and asset allocation.

Bottom line

If you’re self-employed and looking for a way to contribute to a tax-advantaged retirement plan, a SEP IRA can be a good option. It offers you the chance to contribute a hefty sum each year and have your savings grow tax-deferred. A SEP IRA can be especially useful if you don’t have any other employees — and don’t plan to hire them in the future.

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