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How SEP IRAs work: What business owners need to know

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JLco - Julia Amaral/Getty Images/iStockphoto

If you're a small business owner, retirement plans don't have to be too costly or complex. A Simplified Employee Pension individual retirement account (SEP IRA) is an easy-to-manage solution to help create a retirement savings plan for you (and your employees). It provides a tax-advantaged opportunity to save for retirement while still leaving plenty of flexibility when it comes to making contributions.

Here are all the key details you need to know about SEP IRAs—from what they are and how they work to their pros and cons.

What is a SEP IRA?

A SEP IRA is a retirement savings plan for small business owners, either with or without employees. It offers a convenient way for you to contribute to your employees' retirement savings as well as your own. Contributions are made with pretax dollars and those funds grow tax-deferred, which means the tax liability will not occur until withdrawals start in retirement. Over time, the assets in your account benefit from the power of compound interest. A SEP IRA is funded with contributions from you as a business owner, up to a maximum amount each year.

SEP IRAs are available to you whether you are self-employed with no employees, or if you own a business and have employees working for you.

What employers need to know about SEP IRAs

How does a SEP IRA work?

Your business can contribute up to the lesser of 25% of each employee's salary annually, or a maximum annual contribution of $66,000 for 2023 or $69,000 for 2024. 

You, as the employer, are not locked into making contributions every year—you can decide whether and how much to contribute on an annual basis. This allows you to tailor your contributions to fit the company's financial situation and goals. From an employer's perspective, SEP IRAs are a great way to provide retirement savings benefits for employees without the extensive administration requirements of a 401(k) plan.

What are the benefits of a SEP IRA for employers?

A SEP IRA can have several benefits for employers:

  • Tax-deductible contributions. Any contributions you make to employee accounts are tax-deductible business expenses.
  • Flexibility. You're not locked into making contributions every year. If cash flow is low, you can choose not to contribute to the plan.
  • Limited administration. Unlike a 401(k) plan, you don't have to file a tax return for a SEP IRA plan. You don't even have to send the IRS a copy of your Form 5305-SEP or other written agreement. This keeps overhead and administration costs low.
  • Potential tax credits. Establishing a SEP IRA for your business may allow you to claim the Retirement Plan Startup Costs Tax Credit. This credit is designed to help offset startup costs for small businesses that set up retirement plans for their employees, and it's worth up to $5,000 per year for three years.

What are the downsides of a SEP IRA for employers?

A SEP IRA can be a great choice if you want to provide retirement benefits to your employees, but you have some potential downsides to consider:

  • Uniform contribution rules. If you decide to contribute to the plan, your contributions to each employee's account—including your own—must be consistent. For example, you can't reward an especially valuable employee by contributing a larger percentage of their salary to their SEP account.
  • Employees can't contribute. Unlike 401(k) plans, employees can't make pretax salary deferrals to their SEP IRA accounts. This could make it hard to attract employees who want to maximize their retirement savings.

How do you set up a SEP IRA?

Setting up a SEP IRA is relatively straightforward. To begin, you must create the plan with an approved financial institution or broker. You also need to execute a written agreement to provide benefits to all employees. You can find a model SEP agreement in Form 5305-SEP, or use the form your financial institution provides.

Next, your eligible employees must establish their own individual accounts within the plan. After that, you can start contributing to employee accounts.

You have until business tax filing day—plus extensions—to establish a SEP IRA and make deductible contributions.

What employees need to know about SEP IRAs

How does a SEP IRA work for employees?

From an employee's perspective, SEP IRAs provide an excellent tax-advantaged opportunity to save for retirement. Employer contributions to the plan are tax-deferred and don't count as taxable income, meaning you don't have to pay taxes on the money until you start taking distributions from the account.

Additionally, since contributions are employer-funded, you don't need to contribute your own funds to the SEP IRA—you simply take advantage of whatever your employer decides to contribute. This makes it ideal if you want to save for retirement without worrying about finding the funds yourself.

Who can contribute to a SEP IRA?

As an employee, you must meet certain criteria to participate in an employer-sponsored SEP IRA. Those requirements typically include:

  • Age 21 or older
  • Worked for the employer for at least three of the last five years
  • Received at least $750 in compensation for 2023 or 2024

Your employer can use less restrictive requirements than these but not more restrictive ones.

What are the benefits of a SEP IRA for employees?

Contributing to a SEP IRA can have several benefits for employees:

  • Tax-deferred growth. Money in your account grows tax-free, and you don't need to worry about paying taxes on the money until you start taking withdrawals.
  • No vesting requirements. Any contributions your employer makes to your SEP IRA account are 100% vested, or owned, by you.
  • Flexible rollovers*. If you leave your job, you can consolidate your retirement accounts by rolling over the funds in your SEP IRA account to another type of retirement account, such as a traditional IRA or 401(k) plan.

What are the downsides of a SEP IRA for employees?

When it comes to retirement savings, a SEP IRA can be a great choice for employees and employers alike. However, these plans come with some potential downsides for employees:

  • Contributions aren't certain. Contributions to a SEP IRA are employer-funded and not mandatory. So if your employer decides not to make contributions for any reason—say, due to cash flow concerns—you don't get any money in your account. If this is the case, you may need to supplement your retirement savings in another way.
  • Limited early withdrawal options. Unlike some 401(k) accounts, you can't take a loan from a SEP IRA. If you withdraw money from your SEP IRA account before age 59½, you owe taxes on the withdrawal at your ordinary income tax rates and may owe a 10% early withdrawal penalty.

Setting up a SEP IRA for your business

SEP IRAs are an attractive option for small business owners who want to extend retirement benefits to their employees, or people who are self-employed and want to focus on saving for their own retirement. They're relatively inexpensive to set up, simple to manage and have the potential for a rewarding return on your investments. Plus, you may qualify for valuable tax credits when you set one up.

If you're a small business owner looking for a cost-efficient way of helping your staff save for retirement, contact a financial advisor to get started. They can help you review the available options and craft the ideal solution for maximizing your retirement savings.

*There may be benefits to leaving your account in your employer plan if allowed: You will continue to benefit from tax deferral; there may be investment options unique to your plan; fees and expenses may be lower; plan assets have unlimited protection from creditors under federal law; there is a possibility for loans; and distributions are penalty-free if you terminate service at age 55+. Consult your tax professional prior to requesting a rollover from your employer plan.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.