A complete guide to SEP IRAs: Why those who are self-employed should take a look
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About 16 million people in the U.S. are self-employed, according to a 2021 report from the Pew Research Center. For many of these workers, planning for retirement has its own quirks and challenges. They can’t rely on a company for a retirement plan, 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 other savings options to boost the size of their retirement nest egg, including the SEP IRA.
With a higher contribution maximum and a lot of flexibility, the SEP IRA might be the retirement plan that best suits many self-employed workers.
What is a SEP IRA?
A SEP IRA, or Simplified Employee Pension Individual Retirement Account, has many features similar to an 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-advantaged retirement plan for anyone who is self-employed, owns a business, employs others, or earns freelance income. SEP IRA contributions are considered employer contributions, so the business makes them to the employee (which may be 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 (traditional) or after-tax (Roth) retirement contributions as a self-employed person
- Contribute the lesser of 25 percent of your income or $66,000 for 2023
- Easy to open with an account provider
- Must contribute an equal percentage of compensation for any employees
SEP IRA rules
First of all, rather than limiting your annual IRA contributions to $6,500 — the maximum that workers under age 50 can contribute to traditional and Roth plans in 2023 — SEP IRAs allow a company to contribute up to the lesser of 25 percent of your compensation or $66,000. For 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 2023 employee contributions at $22,500.
The SEP IRA is subject to the same investment, distribution and rollover rules as IRAs, according to the IRS.
- Traditional SEP IRA: While you can take distributions from your SEP IRA at any time, 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 73, as you would with a traditional IRA.
- Roth SEP IRA: The Roth SEP IRA was created in 2023, as part of the SECURE Act 2.0. You may take out contributions at any point without tax or penalty, since you’ve already paid tax on the money. But any earnings withdrawn before the age of 59 ½ are subject to a 10 percent tax penalty. There are no required minimum distributions on Roth accounts.
You’re eligible to contribute to a SEP IRA 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) with that employer. Plus, a SEP IRA is different from an IRA, so you can contribute to both.
“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, a financial advisor.
Realize, though, that if you end up hiring people, the SEP IRA must treat them the same as you. 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. 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. For some business owners, a SIMPLE IRA might offer a better solution.
If you open a SEP IRA at a brokerage, the account allows you to invest in potentially high-return assets such as stocks and stock funds. But you’ll also be able to invest in a whole range of securities offered by the brokerage, including bonds, options and more.
SEP IRA contribution limits
The contribution limit for a SEP IRA for 2023 is straightforward. Your maximum contribution is the lesser of:
- 25 percent of the employee’s compensation
- $66,000 (in 2023)
Remember, the SEP IRA is an employer contribution (not an employee contribution), so it’s made by the company rather than the individual worker. There are no catch-up provisions for older workers in SEP IRAs.
Pros and cons of a SEP IRA
The SEP IRA is a popular retirement plan for the self-employed because it offers many useful advantages, but it’s not the perfect plan for everyone.
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 the SEP IRA can help.
- Tax-deferred or tax-free: You can choose to contribute on pre-tax basis (traditional) or after-tax basis (Roth), meaning your money will not be taxed until withdrawn or it will come out entirely tax-free, depending on which plan type you choose.
- 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) at a typical employer, though a solo 401(k) may let you save even more.
- Flexibility: You don’t have to contribute every year, whether 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 you do to your own SEP account.
- 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.
SEP IRA vs. a 401(k) vs. a Roth IRA
The SEP IRA is a popular retirement account, and those who have the option for a SEP IRA may also be considering a 401(k) or a Roth IRA account. Here are some of the key differences:
- A SEP IRA is available only if your employer offers it, and in some cases, the employer may be you. If you’re a single freelancer, the account allows you to stash as much as 25 percent of your company’s earnings to your account tax-deferred, up to an annual maximum of $66,000. The account’s distribution rules are like those of a traditional IRA or Roth IRA, depending on which type of plan you’ve selected.
- A 401(k) is an employer-sponsored retirement plan that lets you save money on a tax-deferred or tax-free basis. Employees can save up to $22,500 (in 2023), and employers may add matching funds into the account as well. The account comes in two major varieties: the (pretax) traditional 401(k) or the (after-tax) Roth 401(k). One-person businesses may also open a solo 401(k) and save even more.
- A Roth IRA allows anyone with earned income (or even spouses of those with earned income) to contribute. Contributions are made with after-tax money, and you’ll be able to grow the account tax-free and then withdraw your money tax-free in retirement. Annual contributions are limited to $6,500 (in 2023).
The good news is that you can contribute to all these plans. However, your maximum contribution to the SEP IRA and the 401(k) together is $66,000, including both employer and employee contributions. You can max out your employee contribution in the 401(k) at your day job, taking full advantage of an employer match there, and then still add money to your SEP IRA, until you hit the annual maximum.
And regardless of how much you contribute to either a 401(k) or a SEP IRA, you’re still able to contribute to a Roth IRA (or a traditional IRA), up to the annual maximum.
How to open a SEP IRA
Setting up a SEP IRA is simple. Start by filling out and filing IRS Form 5305-SEP. Rather than sending the form to the IRS on your own, you can use a broker like Fidelity Investments 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 other 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 retirement, many experts suggest reducing the risk of your portfolio and boosting its income component by rebalancing it 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.
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 or even tax-free. 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.