Understanding SEP IRAs (Simplified Employee Pension)

Important Note

This information is for educational purposes only. Our firm does not provide legal, tax, or accounting advice. This guide should not be considered legal, tax, or accounting advice. Please consult with qualified professionals about your specific situation before making retirement planning decisions.

What Is a SEP IRA?

A Simplified Employee Pension IRA (SEP IRA) is a retirement savings plan designed for self-employed individuals and small business owners. Created by Congress to provide an easy, low-cost retirement option for entrepreneurs, SEP IRAs allow substantially higher contributions than traditional IRAs while maintaining minimal administrative requirements.

Think of a SEP IRA as a supercharged Traditional IRA for business owners. You can contribute up to 25% of your net self-employment income—potentially tens of thousands of dollars annually—with the simplicity of a basic IRA. It’s the easiest high-contribution retirement plan available.

How SEP IRAs Work

The basic process:

Establish the plan: Complete IRS Form 5305-SEP or use a financial institution’s plan
Create SEP IRAs: Open accounts for yourself and any eligible employees
Make employer contributions: Contribute up to 25% of compensation
Invest the funds: Choose from available investment options
Receive tax deduction: Contributions reduce taxable income
Withdraw in retirement: Pay ordinary income tax on distributions

The Key Feature

Only the employer contributes to SEP IRAs—there are no employee elective deferrals. This simplifies administration but means self-employed individuals are solely responsible for funding their retirement.

Contribution Limits for 2026

SEP IRAs offer some of the highest retirement contribution limits:

Maximum Contribution

25% of compensation (or 20% of net self-employment income after the self-employment tax deduction)
Dollar cap: $72,000 (2026)
Whichever is less

For Self-Employed Individuals

The calculation is slightly complex:

Start with net self-employment income
Subtract half of self-employment tax
Calculate 20% of that amount (not 25%)
Maximum: $72,000

Example Calculation

Self-employed consultant earning $200,000:

Net self-employment income: $200,000
Self-employment tax deduction: ~$14,130
Adjusted income: $185,870
Maximum SEP contribution: $37,174 (20% × $185,870)

Compensation Cap

The maximum compensation considered for contributions is $350,000 (2026). Even if you earn $500,000, only the first $350,000 counts for the 25% calculation.

Tax Benefits

Immediate Tax Deduction

Contributions reduce your taxable income:

$50,000 contribution × 37% bracket = $18,500 tax savings
Business deduction for employers
Above-the-line deduction for self-employed

Tax-Deferred Growth

All investment returns compound without annual taxation:

No tax on dividends
No tax on capital gains
No tax on interest
Maximum compounding power

Taxes in Retirement

Withdrawals are taxed as ordinary income:

Typically in lower tax bracket
Spread income over many years
Required distributions starting at age 73

Who Should Consider a SEP IRA?

Ideal Candidates

SEP IRAs work best for:

Solo practitioners and consultants
Freelancers with variable income
Small business owners with few or no employees
Side-gig workers with self-employment income
Those wanting high contributions with minimal paperwork
People who can’t afford employees’ contributions

Less Suitable For

Think twice if you:

Have many employees (required equal contributions)
Want employee salary deferrals
Need catch-up contributions (SEP IRAs don’t allow them)
Prefer Roth contributions
Have highly compensated employees relative to your income

SEP IRA vs. Other Retirement Plans

SEP IRA vs. Solo 401(k)

SEP IRA Advantages:

Simpler to establish and maintain
No annual filings (Form 5500 not required)
Easier administration
Good for inconsistent income

Solo 401(k) Advantages:

Higher contribution potential for moderate incomes
Employee elective deferrals allowed
Catch-up contributions for 50+
Roth option available
Loan provisions possible

SEP IRA vs. SIMPLE IRA

SEP IRA Advantages:

Much higher contribution limits
Employer decides annual contribution
More flexibility year to year

SIMPLE IRA Advantages:

Employee salary deferrals
Lower employer costs for employee businesses
Catch-up contributions allowed

SEP IRA vs. Traditional IRA

SEP IRA Advantages:

Much higher limits ($72,000 vs. $7,500)
Business deduction
Same investment flexibility

Traditional IRA Advantages:

Available without self-employment
Lower complexity
Catch-up contributions

Establishing a SEP IRA

Setting Up the Plan

Three options:

IRS Form 5305-SEP: Free model plan document
Prototype plan: Financial institution’s pre-approved document
Custom plan: Attorney-drafted (rarely necessary)

Timing

Establish by tax filing deadline (including extensions)
Can set up in one year for prior year contribution
Example: Create plan in April 2027 for 2026 tax year

Where to Open

Brokerage firms (Fidelity, Schwab, Vanguard)
Banks and credit unions
Mutual fund companies
Online investment platforms

Employee Coverage Requirements

If you have employees, SEP IRAs have strict rules:

Who Must Be Covered

You must contribute for employees who:

Are at least 21 years old
Have worked for you in 3 of the last 5 years
Earned at least $750 in the current year (2026)

Equal Percentage Rule

Critical requirement: All eligible employees must receive the same percentage of compensation as you contribute for yourself.

Example:

You contribute 15% for yourself
Must contribute 15% for all eligible employees
Cannot contribute more for yourself

Excludable Employees

You may exclude:

Union employees with retirement benefits in their agreement
Nonresident aliens with no U.S. income

Contribution Flexibility

Year-to-Year Variation

One of SEP IRA’s best features:

No minimum contribution required
Can vary from 0% to 25% annually
Decide at tax time, not year-beginning
Perfect for variable income

Example Scenario

Year 1 (good year): Contribute $60,000
Year 2 (bad year): Contribute $0
Year 3 (moderate): Contribute $25,000
No penalties, no complications

Investment Options

SEP IRAs offer the same investment universe as Traditional IRAs:

Available Investments

Stocks and bonds
Mutual funds and ETFs
Index funds
Target-date funds
CDs and money market funds
Real estate investment trusts (REITs)
Alternative investments (with self-directed)

Investment Strategy

Apply standard retirement investment principles:

Diversified portfolio
Low-cost index funds
Appropriate asset allocation for timeline
Rebalance periodically

Withdrawals and Distributions

Before Age 59½

Early withdrawals generally incur:

Ordinary income tax on full amount
10% early withdrawal penalty

Penalty Exceptions

Avoid the 10% penalty for:

Disability
Death (distributions to beneficiaries)
Substantially equal periodic payments (72(t))
Medical expenses exceeding 7.5% of AGI
Health insurance while unemployed
First-time home purchase (up to $10,000)
Higher education expenses
IRS levy

Required Minimum Distributions (RMDs)

Starting at age 73:

Must begin distributions
Based on life expectancy tables
Penalty for missed RMDs: 25% (10% if corrected quickly)
Age increases to 75 in 2033

SEP IRA Strategies

The Deadline Extension Strategy

Maximize flexibility:

File for tax extension
Evaluate full year’s income
Establish and fund SEP by extended deadline
Make informed contribution decision

The Variable Income Approach

For fluctuating earnings:

High-income years: Maximum contribution
Low-income years: Minimal or no contribution
Average out over career
No commitment required

The Side Business Strategy

For W-2 employees with side income:

Contribute to employer 401(k)
Open SEP for self-employment income
Additional tax-advantaged savings
Separate limits apply

The Catch-Up Alternative

Since SEP IRAs lack catch-up contributions:

Open Traditional IRA alongside SEP
Contribute $7,500 ($8,500 if 50+) to Traditional IRA
May not be deductible depending on income
Consider Roth IRA instead

Common Mistakes to Avoid

Unequal Employee Contributions

Must contribute same percentage for all eligible employees
IRS can disqualify plan
Back taxes and penalties possible

Missing Contribution Deadlines

Must contribute by tax filing deadline (with extensions)
Can’t make up missed contributions
Plan ahead each year

Exceeding Limits

25% of compensation cap
$72,000 dollar limit
Excess contributions incur penalties

Ignoring Employees

Part-time workers may qualify
Review employee eligibility annually
Document exclusions properly

Not Considering Alternatives

Solo 401(k) may allow more for moderate incomes
Roth options unavailable in SEP
Evaluate all options

Converting to Other Plans

SEP to 401(k)

As business grows:

May want employee deferrals
Can terminate SEP
Roll SEP assets to new 401(k)
Establish proper 401(k) plan

SEP to Roth IRA

For Roth conversion:

Roll SEP to Traditional IRA
Convert Traditional IRA to Roth
Pay tax on conversion
Tax-free growth thereafter

Multiple Plans

Can maintain:

SEP for one business
401(k) for another business
Limits are aggregated
Complex but possible

Recent Changes and Updates

SECURE 2.0 Impacts

RMD age increasing to 73 (now), 75 (2033)
Reduced RMD penalties
No Roth SEP option yet (unlike SIMPLE IRAs)
Part-time worker rules don’t affect SEP eligibility requirements

State Considerations

Some states offer:

Additional tax benefits
State-sponsored retirement programs
Payroll deduction requirements for employers

SEP IRA Administration

Annual Requirements

Minimal paperwork:

No annual IRS filings required
No discrimination testing
No Form 5500 filing
Keep contribution records
Maintain plan document

Record Keeping

Track and retain:

Plan establishment documents
Contribution amounts and dates
Employee eligibility determinations
Distribution records
Investment statements

Amending the Plan

May need to amend for:

Law changes
Adding vesting schedule
Changing eligibility requirements
IRS provides model amendments

Who Benefits Most?

Perfect Scenarios

SEP IRAs shine for:

Solo consultants earning $100,000+
Real estate agents with variable income
Freelancers with no employees
Small practices with minimal staff
Businesses wanting year-to-year flexibility

The Math Advantage

Self-employed earning $300,000:

Maximum SEP contribution: ~$55,000
Tax savings (37% bracket): ~$20,350
Plus state tax savings
Significant wealth building

The Bottom Line

SEP IRAs offer self-employed individuals and small business owners a powerful combination of high contribution limits, administrative simplicity, and flexibility. The ability to contribute up to $72,000 annually while maintaining year-to-year discretion makes SEP IRAs particularly attractive for those with variable income.

The key advantages—no annual filings, simple establishment, and deadline flexibility—make SEP IRAs the easiest high-contribution retirement plan available. For solo practitioners and small businesses with few employees, the SEP IRA often provides the optimal balance of tax savings and simplicity.

However, if you have employees, the equal contribution requirement can become expensive. And for moderate incomes, a Solo 401(k) may actually allow higher contributions. Evaluate your specific situation, including income level, employee count, and desire for Roth contributions, before choosing.

For the right person—a high-earning self-employed individual with few or no employees—the SEP IRA remains one of the best retirement savings vehicles available, combining substantial tax benefits with remarkable ease of use.

This guide provides general educational information about SEP IRAs. Individual circumstances vary, and contribution calculations can be complex for self-employed individuals. Consult with qualified tax and financial professionals for advice about your personal situation.