How a SEP IRA works: What business owners need to know

Small business owners (and the employees who work for them) can use a Simplified Employee Pension (SEP) IRA to build retirement savings without a heavy administrative burden. A SEP IRA provides a tax‑advantaged way to save for retirement while giving business owners flexibility to adjust contributions as their income or cash flow changes.

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

A SEP IRA is a flexible, tax-advantaged retirement plan designed for self-employed individuals and small business owners, either with or without employees. It allows you to make employer contributions on behalf of yourself and any eligible employees directly into an Individual Retirement Account (IRA). You make contributions with pre-tax dollars, the money grows on a tax-deferred basis, and you only pay taxes when you take withdrawals in retirement. This tax-deferred status helps reduce your current taxable income.

One major advantage of a SEP IRA is its higher contribution limit compared to traditional and Roth IRAs, which can help accelerate long‑term retirement and wealth‑building goals. The plan is simple to set up, requires minimal paperwork and works whether you're a sole proprietor, freelancer or business owner with employees. Over time, your investments can compound and grow into a sizable retirement nest egg.

A SEP IRA works by allowing employers and self-employed individuals to make tax-deductible contributions into retirement accounts for themselves and their employees, with taxes deferred until they take withdrawals in retirement.

SEP IRAs are funded entirely by employers—employees don't contribute. They're popular for self-employed people because of their simplicity: minimal paperwork, no annual IRS filings and easy setup.

In 2026, employers can contribute up to 25% of an employee's compensation, capped at $72,000 (an increase from $70,000 in 2025). That makes SEP IRAs a powerful tool for small businesses looking to offer meaningful retirement benefits without the administrative burden of traditional plans.

Contributions are flexible, meaning you don't have to contribute every year, so the percentage can vary depending on your company's financial situation. However, you must make contributions at the same percentage of compensation for all eligible employees, including yourself.

Employers make all SEP IRA contributions, so employees don't contribute their own money. Contributions are tax-deferred, meaning they don't count as taxable income in the year of the contribution. Distributions may be taxable when they start taking withdrawals in retirement. This is what we refer to as "tax later" treatment.

Funds in the account grow through compounded investment returns, helping employees build a meaningful retirement nest egg over time.

Because of their tax benefits, SEP IRAs can play an important role in a broader tax-efficient financial strategy that includes retirement planning and long‑term wealth transfer.

Almost any kind of business can open a SEP IRA, whether you're a sole proprietor, partnership, corporation or limited liability company (LLC). This makes it especially attractive to self-employed professionals and small business owners looking for a simple, tax-advantaged retirement plan. A SEP IRA for a self-employed person lets you save for retirement on your own terms while reducing your current taxable income.

Employees must be included in the SEP IRA if they meet the following IRS eligibility rules, though employers may choose to set looser requirements:

• At least 21 years old
• Worked for the employer in at least three of the last five years
• Earned at least $750 in compensation from the business for 2026

You may choose to allow younger, newer or lower-compensated employees to participate, which can support broader workforce benefits and long‑term retention, but eligibility rules must be applied consistently.

For business owners, SEP IRAs offer a straightforward way to provide retirement benefits and support long‑term financial security for employees without the administrative burden of more complex plans, such as 401(k)s or defined benefit plans.

The rules are designed to keep costs low and flexibility high, making SEP IRAs especially appealing for small businesses and startups. Understanding the potential advantages and drawbacks will help you decide if this plan is the right fit for your company.

A SEP IRA offers several advantages for business owners:

• Tax-deductible contributions. Employer contributions are deductible as a business expense, lowering your taxable income.
• Flexibility. SEP IRA rules allow you to choose whether and how much to contribute each year, giving you the option to skip contributions during lean times.
• Limited administration. Unlike 401(k) plans, SEP IRAs don't require annual filings with the IRS, so they keep paperwork and costs to a minimum.
• Startup tax credit. Establishing a SEP IRA may qualify you for the retirement plan startup costs tax credit, which is worth up to $5,000 annually for the first three years. This tax credit helps offset the expense of setting up and administering the plan.

No retirement plan option is right for every situation. As with anything, there are some limitations to consider:

• Uniform contribution rules. If you contribute, it must be the same percentage of salary for all eligible employees, including yourself. This prevents you from making larger contributions to select workers.
• No employee contributions. Unlike 401(k) plans, employees can't defer part of their own salary into a SEP IRA. This may limit the appeal for workers looking to save more aggressively.

By weighing these benefits and downsides, you can decide whether a SEP IRA aligns with your business goals and resources.

For employees, a SEP IRA can be a valuable workplace benefit that helps build long-term retirement savings without requiring personal contributions. Because the employer makes contributions directly to the employee's account, workers gain immediate ownership of the funds and the opportunity for tax-deferred growth.

A SEP IRA provides several advantages for workers:

• Tax-deferred growth. Contributions grow tax-free until withdrawn, allowing the balance to compound over time.
• No vesting requirements. Employer contributions are 100% vested from day one.
• Flexible rollovers. If the employee changes jobs, they can consolidate retirement accounts by rolling their SEP IRA into a traditional IRA or a 401(k), preserving tax advantages and simplifying management.

SEP IRAs are less flexible than other investment options for employees. Here's what to consider:

• Contributions aren't guaranteed. Employers decide each year whether to fund the plan. If the employer doesn't contribute, growth is limited to investment returns.
• No employee contributions. Unlike 401(k) plans, employees can't contribute a portion of their own salary to boost retirement savings.
• Early withdrawal penalties. Taking money out before age 59½ typically results in ordinary income taxes plus a 10% penalty, and SEP IRAs don't allow loans like some 401(k) plans.

Overall, SEP IRAs provide meaningful employee benefits, but many workers still may want to supplement them with other retirement accounts to support consistent saving and long‑term financial planning.

Setting up a SEP IRA is relatively simple and requires just a few steps:

1. Choose a SEP IRA provider. Many financial institutions or brokerages offer SEP IRAs.

2.  Complete a written agreement. Use IRS Form 5305-SEP or the form provided by your financial institution to establish the plan and define eligibility rules.

3. Open accounts for employees. Once the employer has established the plan, each eligible worker must set up their individual SEP IRA account through the provider.

4. Fund the plan. Make employer contributions to each account, following IRS limits and uniform contribution rules.

5. Meet deadlines. You can open a SEP IRA and make contributions up to your business's tax filing deadline, including extensions.

When deciding how to save for retirement, it helps to compare a SEP IRA with other options, like a traditional IRA and a Roth IRA to understand how each fits into your broader tax and retirement strategy. Each account has different rules for contributions, taxes and withdrawals.

Here's a side-by-side look at the key differences:

SEP IRAs are an attractive option for small business owners who want to extend retirement benefits to employees or for self-employed individuals who want to prioritize their own retirement savings. They're cost-efficient to set up, simple to manage and offer meaningful tax advantages.

Before opening an account, it’s important to consider how SEP IRA contributions fit into your broader retirement strategy, tax planning and long‑term financial goals. A Thrivent financial advisor can help you evaluate whether a SEP IRA is right for you, explain how it fits into a tax-efficient plan and guide you toward the best path forward.