A complete guide to SEP IRAs: Why those who are self-employed should take a look

Bernardbodo/Adobe Stock

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 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 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 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. 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 $61,000 for 2022
  • Easy to open with an account provider
  • No Roth option
  • Must contribute an equal percentage of compensation for any employees

SEP IRA rules

First of all, rather than limiting your annual IRA contributions to $6,000 — the maximum that workers under age 50 can contribute to traditional and Roth plans in 2022 — SEP IRAs allow a company to contribute up to the lesser of 25 percent of your compensation or $61,000. 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 2022 contributions at $20,500.

The SEP is 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, 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 72, 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, a financial advisor.

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.

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 2022 is straightforward. Your maximum contribution is the lesser of:

  • 25 percent of the employee’s compensation
  • $61,000 (in 2022)

Remember, the SEP IRA is an employer contribution (not an employee contribution), so it’s made by the company rather than the individual worker.

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 $61,000. The account’s distribution rules are like those of a traditional IRA.
  • 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 $20,500 (in 2022), 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).
  • 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 $6,000 (in 2022).

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 $61,000, including both employer and employee contributions. You can max out your employee contribution in the 401(k) at your day job, 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.

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 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 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.)
  • 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-deferred, you will still be on the hook for taxes when you take distributions. You’ll also be subject to required minimum distributions later.

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 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 your retirement date, 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.

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.

Learn more: