How to Set up a SEP IRA

How to Set up a SEP IRA

This guide for small business owners will help set up and run these popular retirement plans

Reviewed by Ebony Howard
Fact checked by Rukshani Lye

How to Set up a SEP IRA

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If you want to establish a retirement plan for your business, you may want to consider establishing a Simplified Employee Pension (SEP). For starters, SEPs have a more flexible contribution deadline than qualified plans—SEP contributions can be made up until the due date of the employer’s tax return (including extensions), while qualified plans have varying deadlines depending on the type of plan.

SEPs also offer several other attractive features that we’ll review here, along with other factors to consider before choosing a SEP for your business.

Key Takeaways

  • SEP IRAs are attractive for the self-employed, freelancers, and small businesses because they are easy to set up and administer.
  • Employers can contribute up to 25% of each eligible employee’s gross annual salary and up to 20% of their net adjusted annual self-employment income if they are self-employed, provided the contributions don’t exceed $66,000 per person for the year 2023 ($61,000 for 2022).
  • Certain categories of employees may be ineligible to participate in a SEP, including anyone who is under 21 or who makes less than $750 in wages from your business for the year 2024 ($750 for 2023).
  • An employer may deduct plan contributions as a business expense.
  • A SEP may not be desirable because it provides 100% vesting, it doesn’t allow loans to be taken out against it, and employees may be eligible after as little as three months.

What Is a Simplified Employee Pension (SEP)?

A SEP is a retirement plan based on an individual retirement account (IRA) into which business owners can make pre-tax contributions for both themselves and their eligible employees. It is ideally suited for self-employed workers, freelancers, and small-business owners because it’s easy to establish and administer.

Any business owner with one or more employees, or anyone with freelance income, can open a SEP IRA. Unlike qualified plans, the SEP does not require nondiscrimination testing or filing of 5500 returns. Establishing a SEP IRA can be relatively more straightforward than other retirement plans. With lower administrative costs and flexible annual contributions, a SEP is an excellent option for small businesses with variable cash flow.

Employees are responsible for enrolling in an employer-sponsored IRA to receive contributions. However, with a SEP, employees themselves do not make contributions. An employer who sets up a SEP has no responsibility for assisting with investing plan contributions, instead, individual participants select their IRA provider and direct their investments. SEP IRA accounts follow the same rules of investment, distribution, and rollover as traditional IRAs.

As with many other employer plans, an employer has until the tax-filing deadline of the business, including extensions, to fund the SEP.

The SECURE Acts and Small Businesses

In December 2019, former President Donald Trump signed the Setting Every Community Up for Retirement Enhancement (SECURE) Act. The Act aims to simplify and reduce costs for small business owners setting up “safe harbor” retirement plans, enhancing retirement security for many Americans. In 2022, the SECURE 2.0 Act further expanded these provisions.

The Acts introduced enhanced tax credits for small business owners, raising the SEP plan startup cost credit from 50% to 100% to cover setup, administration, and employee education costs for up to three years. Moreover, small business owners can receive a tax credit for automatically enrolling workers in retirement plans, in addition to the startup credit.

Contribution Limits

SEP IRAs have appealingly high contribution limits. Employers can contribute up to 25% of each eligible employee’s gross annual salary and up to 20% of their net adjusted annual self-employment income if self-employed, provided the contributions do not exceed $69,000 for 2024 ($66,000 for 2023). Employer contributions must be based on the first $345,000 of compensation in 2024 ($330,000 for 2023) and are adjusted annually.

An employer can decide each year whether to contribute to the SEP, which can be an advantage for a new business that has not established a trend in its annual earnings. Because of this flexibility, an employer could decide to forgo the SEP contribution in years when profits are lower than anticipated. However, when SEP contributions are made, they must be based on the same percentage of compensation for all covered employees.

What’s more, all plan participants who worked for the business during the year for which contributions are made must receive SEP contributions even if they leave their jobs or die before the contributions are made.

Ineligible Employees

Certain categories of employees may be excluded from participating in the SEP for the year, including those who:

  • Are covered under a collective bargaining agreement (unionized employees)
  • Are under the age 21
  • Earned less than $750 (indexed for inflation) for the year
  • Worked less than three of the five preceding years
  • Are nonresident aliens with no U.S. income

How SEPs Work

Here’s an example: Under ABC Inc.’s SEP IRA, an individual must work three of the five preceding years to be eligible to receive a SEP contribution for the year. Jane worked for ABC Inc. on a part-time basis in 2019, 2020, 2021, and 2022.

Assuming Jane meets the other eligibility requirements, she is eligible to receive a contribution for 2024, even if she only worked for a few months or weeks in each year, because she worked for at least three of the five years preceding 2024. For SEP IRAs, a year of service can be any period, meaning that an employee who worked part-time or for just one week in a year is counted as having completed a year of service.

Important

An employer may choose to use less restrictive eligibility requirements to allow more employees to participate in a SEP plan.

Deducting SEP Contributions

The type of business determines the type of form the employer uses to claim the deduction for SEP contributions.

  • A sole proprietor claims the SEP contribution for themselves on IRS Form 1040. However, SEP contributions on behalf of the sole proprietor’s common-law employees (the IRS term for an employee, not an independent contractor) are claimed on Schedule C.
  • Partners in a partnership claim deductions for their individual SEP contributions on IRS Form 1040. For contributions made on behalf of common-law employees, the partnership claims the deduction on IRS Form 1065.
  • For an S corporation, all SEP contributions are claimed on IRS Form 1120-S.
  • For a C corporation, all SEP contributions are claimed on IRS Form 1120.

It is a good idea to consult with your tax professional to ensure the proper forms are filed to report and claim the deduction for SEP contributions.

Deducting Plan Expenses

A business owner may be eligible to receive a tax credit for expenses incurred when establishing a SEP and also may be able to deduct plan expenses, including contributions made to the plan.

Reporting Requirements

For the employer, tax reporting is limited to reporting SEP contributions on the business’s tax return. For individual participants, the IRA custodian or trustee reports SEP IRA contributions on IRS Form 5498 and distributions on IRS Form 1099-R.

Employers and employees should bear in mind that the custodians report contributions in the year they are received. If, for instance, ABC Inc. makes its SEP contributions for 2023 in May of 2024, Form 5498 may not correspond with the amount the employer reports for 2023. Employers should thus maintain their records to keep track of SEP contributions.

Disadvantages of a SEP IRA

From an employer’s viewpoint, there are definite disadvantages of SEP IRAs.

Immediate Vesting

To reduce employee turnover and the cost associated with training new employees, some employers want their workers to be employed for several years before they are vested in the employer’s contributions. For SEP IRAs, however, contributions are immediately 100% vested, which means that future vesting is not a tool to lower employee turnover. As soon as they are deposited, the contributions belong to the employee.

No Loans Permitted

Unlike most qualified plans—under which participants, including the business owner, may borrow up to the lesser of 50% or $50,000 of their vested balance—the SEP, like all IRA-based plans, does not have this feature.

Employee Eligibility Requirements

For a SEP IRA, a year of service is any period, however short. This can result in increased expenses associated with funding the plan, which may be a disadvantage, particularly for businesses that hire part-time or seasonal employees.

What’s the Difference Between a SEP IRA and a Traditional IRA?

A simplified employee pension, or SEP, is a type of simplified retirement account for small businesses and self-employed people who do not have the resources for a traditional employer-sponsored plan. With a SEP, the employer makes contributions on behalf of the employee, who directs how the assets are to be invested. Employers can contribute up to 25% of an employee’s annual salary, up to a certain limit ($69,000 for 2024). This is in contrast to a traditional IRA, where an employee can contribute up to $7,500 of their pre-tax income.

What Is the 3 of 5 Rule for SEP IRAs?

The 3-of-5 rule states that if an organization has a SEP IRA, it must include any employee over age 21 who has worked for the organization for three of the past five years.

How Do You Set Up a SEP IRA?

In order to set up a simplified employee pension (SEP), employers must first choose the financial institution that will receive the funds on behalf of the plan. Then, they must execute a written agreement stating the name of the employer, the rules for eligibility, and how the plan contributions will be allocated. The final step is to set up the SEP for each employee and begin contributions.

The Bottom Line

Like many small business owners, you may enjoy the simplicity and inexpensive administration of the SEP IRA. While it may be convenient to establish the SEP, you should consult your tax professional to ensure that the plan you choose is suitable for your business profile. If you prefer a qualified plan to a SEP IRA, but you missed the deadline to establish a qualified plan, you may fund the SEP and then roll over the balance to a qualified plan you establish later.

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