[Updated with latest IRS 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 on small business retirement plans 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 with most large brokers.
Further since I was still doing my 9-to-5 job while growing my side/small business, I was able to have both a SEP IRA and 401K plan that I get from my employer without any adverse tax impacts and essentially double my pre-tax contributions.
Here are some more details and rules around SEP IRA plans you need to be aware of. It can be a bit tricky to calculate your qualified contribution based on your entity and employment type. So hopefully the examples below help you.
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 personally use and recommend using Fidelity, Charles Schwab or Vanguard as they have the most investment options and take care of most of the administration. See sections below on some of the IRS forms/declarations the employer needs to make to open/run a SEP IRA plan.
Its important to note that contributions can only be made to a SEP IRA with self-employment income even if you participate in a 401k, 403b, or 457 or other employer sponsored retirement plan.
This allows you to significantly boost you pre-tax retirement savings and reduce taxable pass-through business income taxes.
Latest 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 in mid-April or the tax deadline of the following year — i.e., you have up to April 15th 2024, to contribute into a 2023 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||$69,000 or 25% of compensation||$66,000 or 25% of compensation||$61,000 or 25% of compensation|
|SEP Minimum compensation||$750||$750||$650|
|SEP Annual Compensation Limit||$345,000||$330,000||$305,000|
|SEP Contribution Deadline||April 15, 2025||April 15, 2024||April 17, 2023|
The annual compensation limit is the amount of income that can be factored in for determining your contribution limit to ensure lower paid employees are not discriminated against.
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 IRAs 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.
Self-Employment vs Salaried Employee Contribution Calculation
There are two ways to calculate how much can contribute. It will depend on whether your business pays you a salary (as an employee) or you can use the self-employment method if you just take distributions.
Self-employment net earnings method: Suppose your net earnings (income – business expenses) total $100,000. Multiply by 92.35% to find the adjusted net earnings of $92,350. This adjustment factors in the 7.65% employment tax.
Multiply the adjusted net earning figure by 25% (contribution limit) to find your annual SEP contribution limit of $23,088. If you’re self-employed, your contributions are generally limited to 20% of your net income.
Salary method: If you business pays you salary as an employee (i.e. you get a paycheck with self-employment taxes already deducted), calculate your SEP contribution limit as an employee. So if you are paid $150,000 (your W-2 salary) a year, your employer can add up to $37,500 to your SEP.
You can search online SEP calculators to help you or this Fidelity worksheet.
SEP IRA vs Solo 401K
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.
This means you cannot contribute more to one employee (e.g. yourself) and much less to others, which can be a problem for business that have employees on varied wage bases.
If you want to have variable contributions then a Solo 401K plan may be better for your business, but that has lower overall limits (in line with regular IRAs) than a SEP IRA
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 2022 SEP IRA plans, the plan creation and contribution deadline is April 17, 2023.
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 I don’t know how much I will make to figure my SEP IRA contribution?
A lot of business owners are also not sure how much compensation they will make during the year – this could be due to inherent volatility in earnings or a sudden change in income due to variable factors during the year.
In this situation, and to avoid IRS penalties and interest with contributing more than you are allowed, business owners can take advantage of the fact that you have until the tax filing deadline to open and fund a SEP IRA.
So for example in calendar tax year 2022, you can open and fund a SEP IRA all the way until mid-April 2023.
So it is completely normal and often a good idea to wait until the tax year is done to go back and fund your SEP IRA. This way you can adjust your contribution in line with your actual compensation for the year.
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.
What happens to my SEP IRA if I close my business?
Since the employee owns the SEP IRA plan (and all employer contributions) they will own all the funds already in that plan even if the employer stops contributing because the employees leaves, stops earning income from the business or the business closes.
Naturally you will not be able to continue to make contributions to that SEP IRA after this point since contributions are based on active earnings from that business.
You can also withdraw money from your SEP-IRA and deposit it (rollover) into another IRA, which you will have full control over.
How is a SEP officially established (IRS guidance)?
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 according to the IRS.
- 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 (if you are not a solo business owner) 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 (unlike a Solo 401k). SEP-IRAs can be set up with banks, insurance companies, or other qualified financial institutions. Fidelity and Vanguard both offer good options. 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). This is helpful if you have variable or uncertain income during the tax year and are not sure what your full year SEP contribution will be.
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.