[Updated for current year limits] A year or so after starting my small business and completing my first annual tax return that showed a slight profit, my accountant advised that I start looking into a retirement account/plan for my business in order to lower my overall tax bill and also effectively set aside some of my business profits towards retirement.
After doing my research I found that if you’re a one person employee/owner business or a small employer with only a handful of employees, a SEP IRA is the best option because it is relatively easy to setup and administer. The other option is the Solo 401K plan, but this retirement vehicle has some drawbacks as you’ll see in the following sections.
Further, I am able to have both a SEP IRA and 401K plan that I get from my day-job without any adverse tax impacts and essentially double my pre-tax contributions. Here are some more details and rules around SEP IRA plans.
What is a Simplified Employee Pension (SEP) or Retirement plan?
A SEP is a popular and widely used retirement plan management approach because it provides self employed owners or small business owners with a few staff a simplified method to make contributions toward their employees’ retirement and, if self-employed, their own retirement.
Contributions are made directly to an Individual Retirement Account or Annuity set up for each employee (a SEP-IRA). Various brokers provide IRA accounts for small business’. I use personally recommend using Fidelity or Vanguard as they have the most investment options.
Its important to note that contributions can be made to a SEP IRA with self employment income even if you participate in a 401k, 403b, or 457 or other retirement plan. This allows you to significantly boost you pre-tax retirement savings.
Who is Eligible for a SEP IRA?
Any employer can establish a SEP and is independent of company/incorporate type. However the tax advantages and administrative costs can vary based on incorporation rules. An eligible employee for a SEP IRA is one who meets the following requirements:
* attained age 21;
* has worked for the employer in at least 3 of the last 5 years;
* has received the annual minimum compensation amount (see table below) over the last two years from the employer for each year
Like a traditional IRA plan, contributions to a SEP IRA are generally 100% tax deductible and investment earnings in a SEP IRA grow taxed deferred. Withdrawals after age 59 1/2 are taxed as ordinary income. Withdrawals prior to age 59 1/2 may incur a 10% IRS penalty as well as income taxes.
SEP IRA Only Allow Employer Contributions
While traditional and Roth IRAs are accounts most of us set up on our own, outside our workplaces, SEP IRAs are tied to our jobs. A SEP is set up by an employer (including a self-employed person) and permits the employer (not the employee) to make contributions to the SEP IRA accounts of eligible employees. The employer gets a tax deduction for contributions made, and the employee is not taxed on those contributions, though their eventual withdrawals will be taxed at their income tax rate.
Of course, a self-employed person is both employer and employee in this case, so he or she funds their own account.
The one potential drawback with a SEP IRA for small business’ with multiple employee is that the employer contribution must be the same to ALL employee accounts. So you cannot contribute more to one employee (e.g. yourself) and much less to others. If you want to have variable contributions then a Solo 401K plan may be better for your business, but that has lower overall limits than a SEP IRA.
Contribution Limits for SEP IRA plans
The same limits on contributions made to employees’ SEP-IRAs also apply to contributions made to a self-employed individual’s SEP-IRA. Contributions must be made in cash (no stock). The contribution deadline is usually April 15 or the tax deadline of the following year — i.e., you have up to April 15, to contribute for the past year’s SEP IRA. The table below shows the SEP contribution limits over the last few years along with some other key figures
|SEP Employer Contribution Limit||$61,000 or 25% of compensation||$58,000 or 25% of compensation||$57,000 or 25% of compensation||$56,000 or 25% of compensation|
|SEP Minimum compensation||$650||$650||$600||$600|
|SEP Annual Compensation Limit||$305,000||$290,000||$285,000||$280,000|
|SEP Contribution Deadline||April 15, 2023||April 15, 2022||May 17, 2021||Jul 15, 2020|
Can catch-up contributions be made to a SEP?
Generally No. SEPs are funded by employer contributions only. However, catch-up contributions can be made to the IRAs that hold the SEP contributions if the SEP-IRA documents allow.
Sep IRA contribution deadline
The deadline to establish a SEP IRA is generally the tax deadline (including any extensions) of the following year. E.g. for 2020 SEP IRA plans, the plan creation and contribution deadline is May 17, 2021.
Some employers may have earlier deadlines to ensure they can make the required employee contributions and to align with business operations/cashflow constraints.
What if the Employee already contributes to another 401K or IRA Plan? Can they also contribute to a SEP IRA?
You ARE eligible to contribute to a SEP IRA even if you are already covered by a separate 401(k) retirement plan at your full-time job or have retirement plans from other employment sources. The IRS has confirmed this in their FAQ about SEP plans – “Yes, you can set up a SEP for your self-employed business even if you participate in your employer’s retirement plan at a second job.”
However if a SEP IRA and 401K plan are offered by the same employer (e.g a small business with multiple employees) then the individuals aggregate contributions will be limited to the maximum SEP IRA limits shown above.
Are 401(k) or SEP IRA contribution limits the same or different?
No, contributions to a SEP plan are not reduced by contributions to a 401(k) plan, or vice versa. But this is only the case if the employers are different and have no affiliation. If that is the case you can max out your SEP IRA plan AND your 401k contributions. This is a big tax break that many higher income folks with multiple streams of income use to get their pre-tax retirement savings to over 85,000 per year!
Real-life example: Mark has a side hustle where he provides IT consulting to small business. His day job is as a project manager in a bank where he is a full time, salaried (W2) employee.
Mark has incorporated (as an S-Corp) his IT consulting business where he is the owner and sole employee. As the “employer” he can make contributions to his SEP IRA plan up the maximum amount, subject to income considerations discussed above. He can also contribute the maximum in to the 401(k) plan at this day job.
How is a SEP established?
A SEP is established by adopting a SEP agreement and having eligible employees establish SEP-IRAs. There are three basic steps the IRA requires in setting up a SEP, all of which must be satisfied.
- A formal written agreement must be executed. This written agreement may be satisfied by adopting IRS Form 5305-SEP, Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement. Banks, insurance companies, and other qualified financial institutions have templates/prototypes to help you with this.
- Each eligible employee must be given certain information about the SEP. If the SEP was established using the Form 5305-SEP, the information must include a copy of the Form 5305-SEP, its instructions, and the other information listed in the Form 5305-SEP instructions.
- A SEP-IRA must be set up for each eligible employee. SEP-IRAs can be set up with banks, insurance companies, or other qualified financial institutions. The SEP-IRA is owned and controlled by the employee and the employer sends the SEP contributions to the financial institution where the SEP-IRA is maintained.
A SEP can be set as late as the due date (including extensions) of the business’s income tax return for that year (see deadline discussion above). Unlike a 401k where the employer has to file a IRS Form 5500, a SEP IRA is much easier to establish which makes the administrative overhead much more manageable.
If you’ve contributed more than the annual limits to an employee’s SEP-IRA, you can see this IRS procedure to correct your over contribution.