SEP IRA

A SEP IRA is a simplified employee pension, an employer-funded retirement arrangement in which the employer contributes to a traditional IRA established for each eligible employee. The naming is worth untangling because it explains most of the mechanics. The IRS describes a SEP as a plan that "allows employers to contribute to traditional IRAs (SEP-IRAs) set up for employees," and the model document, Form 5305-SEP, is titled "Simplified Employee Pension — Individual Retirement Accounts Contribution Agreement." So the SEP is the plan layer, and the underlying account is an ordinary traditional IRA that happens to be receiving employer money. Everything that follows from being a traditional IRA still applies, including the aggregation rule that treats all of a person's traditional, SEP, and SIMPLE IRAs as one pool when a distribution or conversion is taxed.

There are no employee deferrals, and the reason is historical. An earlier variant did allow salary reduction, but Publication 560 closes that door in one sentence: "You aren't allowed to set up a SARSEP after 1996." Anything created since is employer-funded only. That single fact drives several others. Because catch-up contributions are defined as extra employee deferrals, the IRS confirms there are no catch-up contributions in a SEP, so turning 50 changes nothing. It also means an owner with modest self-employment income can often put more into a solo 401(k), where a flat-dollar deferral is available on top of the employer percentage.

The uniform-percentage rule is what usually decides whether a SEP is a good idea. Section 408(k)(3)(C) treats contributions as discriminatory unless they bear a uniform relationship to each employee's compensation. In plain terms, the owner cannot contribute 25% for themselves and 3% for staff. Compensation counted for each person stops at $360,000. For a one-person business that constraint is invisible; for a business with several employees it is the entire cost analysis.

Coverage is generous and hard to narrow. Section 408(k)(2) requires a contribution for each employee who is at least 21, performed service in at least 3 of the immediately preceding 5 years, and received at least $800 of compensation for the year. Note that the compensation figure is an eligibility floor, not a contribution cap. An employer may use less restrictive terms but not more restrictive ones. Two further rules catch people out: the IRS states that a SEP cannot impose a last-day-of-the-year employment requirement, so an eligible employee who quit or died mid-year still shares in the contribution, and part-time staff who cross the three-of-five-years test have to be covered even if they never worked a full year.

Money is the employee's immediately. Section 408(k)(4) requires that contributions not be conditioned on being left in the account and that the employer impose no prohibition on withdrawals. There is no vesting schedule to design and none to lose, and an employee can withdraw employer contributions the day they land, subject to ordinary income tax and, before age 59½, the 10% additional tax.

Roth SEPs exist, and this is a recent change. SECURE 2.0 removed the provision that had barred a simplified employee pension from being designated as a Roth IRA, so since 2023 a SEP can be funded on a Roth basis if the documents provide for it. The tax mechanics follow: section 402(h)(1)(C) makes a contribution to a Roth SEP IRA non-excludable, meaning the employee includes it in income in the year it is made. Form 8606 now states that "Roth IRA" includes Roth SEP IRAs. Any source asserting that a SEP cannot be Roth predates the change.

One account can do two jobs. Because a SEP-IRA is a traditional IRA, the IRS confirms that an individual may also make regular annual IRA contributions to it if the account document permits non-SEP contributions. Those personal contributions count against the normal IRA limit, not the SEP limit, and being covered by a SEP makes the person an active participant for purposes of the traditional IRA deduction phase-out, which may make the personal contribution nondeductible.

The employer executes a written agreement, often the IRS model Form 5305-SEP, gives each eligible employee the required information, and opens a SEP-IRA for each of them. Each year the employer decides whether to contribute and at what percentage; there is no obligation to contribute every year. To deduct a contribution for a year, it must be made by the due date of the return including extensions, and the plan itself may be established that late as well. There is no annual Form 5500 obligation, which is the main reason advisers describe the administration as light.

A hypothetical example showing where the cost sits. Maya is the shareholder-employee of an S corporation with W-2 compensation of $180,000, and she has two employees earning $50,000 and $40,000, both long enough tenured to be eligible. She wants the maximum 25% for herself, which is $45,000. The uniform-percentage rule then requires 25% for each employee as well, so $12,500 and $10,000. Total employer outlay is $67,500, of which $22,500 goes to staff. Dropping her own rate to 10% would cut her contribution to $18,000 and the staff cost to $9,000. There is no design available inside a SEP that funds her at 25% and them at 10%.

Pros

• Almost no administration. No annual filing, no testing, no plan document to restate, and no vesting schedule to track.
• It can be adopted and funded after the tax year ends, up to the return due date including extensions, which no qualified plan can match.
• Contributions are entirely discretionary from year to year, so a bad year costs nothing and requires no amendment.
• At higher self-employment income the employer-only percentage can still reach the full defined-contribution limit.
• A Roth version has been available since 2023 for employers whose documents provide for it.

Cons

• The uniform-percentage rule means every dollar the owner contributes for themselves comes with a proportional cost for eligible staff.
• No salary deferrals and no catch-up contributions, so at lower income a solo 401(k) usually allows more.
• Employees are fully vested at once and can withdraw the money immediately, so contributions cannot be used to encourage retention.
• SEP balances aggregate with traditional IRAs under the pro-rata rule, which can make a clean backdoor Roth contribution impossible.
• No plan loans, because IRA-based arrangements cannot offer them.