Home Angel Investor What’s a SEP IRA and How Does it Work?

What’s a SEP IRA and How Does it Work?

What’s a SEP IRA and How Does it Work?


Retirement planning for the self-employed can seem complicated and, often out of reach. Without a traditional workplace 401(k), many business owners and freelancers aren’t sure how to start putting money toward retiring someday. There are, of course, individual options available, specifically Roth and Traditional IRAs. However, their contribution limits may limit your ability to save effectively – especially if your goal is to save 10% or more of your total annual income. 

Enter: the SEP IRA. This specific type of IRA (Individual Retirement Account) opens up your options significantly when it comes to building your retirement nest egg. This retirement savings vehicle is perfect for small business owners or freelancers who are looking for a tax-efficient way to start saving. 

What’s a SEP IRA?

A Simplified Employee Pension Individual Retirement Account (SEP IRA) acts similarly to how a traditional IRA would work. However, there are a few key changes that make it extra-appealing for small business owners. First and foremost, the business owner makes all contributions to a SEP IRA. That’s right, the funds come directly from the business – not out of your paycheck. 

The other big change to keep in mind is that the contribution limits are notably higher than other IRAs. For example, both a Traditional and a Roth IRA have a contribution limit of $6,000 in 2020, or $7,000 if you’re over 50. A SEP IRA, on the other hand, allows contributions up to 25% of your earnings, or $57,000 – whichever is lower. 

This is impressive, as it even outshines the contribution limits of traditional workplace 401(k)s – $19,500 in 2020 if you’re under 50. For a small business owner who may be behind when it comes to building their retirement savings, this option is often an excellent fit. 

How to Calculate How Much You Can Contribute

To know how much you can contribute to your SEP IRA, you have to start by calculating your earnings. If you have a Schedule C for tax filing purposes, start here. In general, you can contribute up to 25% of your net-earnings (per your Schedule C income report) minus any deductions. This may sound complicated, but the IRS conveniently outlines how to calculate your retirement contributions and deductions here. However, if you earn over $285,000 per year, your contributions are capped at $57,000. 

It’s also important to note that contributions do not have to be a consistent earnings percentage year over year. Theoretically, you could contribute 10% one year, and reduce it to 5% another year. 

If you’re a solo business owner, this flexibility is very important. When your income fluctuates, being able to pivot and save more (or less) toward retirement can give you more breathing room to pay your bills and save for other short-term financial goals.

Who Qualifies to Use a SEP IRA?

All businesses qualify to open a SEP IRA. It doesn’t matter if you’re a sole proprietor or a multi-million dollar corporation. However, it’s important to remember that almost all employees are eligible to enroll. In order to participate, they must:

  • Be 21 years or older
  • Earn over $600 per year
  • Have worked for the company for three out of the past five years

The rule is that the employer has to contribute the same amount for every employee who qualifies. So, if you want to contribute up to the full 25% limit to your account, you’d be on the hook for contributing up to 25% of everyone’s salary toward their respective SEP IRAs – yikes.  This rule may mean that the SEP IRA isn’t the best fit for you and your business at this time. 


All contributions made to a SEP IRA are pre-tax. In other words, you deduct the contributions now, and pay income tax on them when you withdraw in retirement. If you’re considering a SEP IRA, it’s in your best interest to reach out to a tax professional to help you maximize your deductions.

Are My Contributions Vested?

All contributions made by the business are immediately vested and available to employees.

How Do I Withdraw Funds?

You can’t withdraw funds from your SEP IRA until you’re age 59 ½ or older. If you do withdraw funds early, you’re subject to a 10% penalty and ordinary income tax on the funds. Let’s look at an example:

You have $10,000 in your SEP IRA. Of the $10,000 balance, only $2,000 is taxable. You’d pay ordinary income taxes on the taxable $2,000 and a 10% penalty for the full $10,000. 

Depending on how much you have saved in your SEP IRA, this could result in a hefty tax bill. Of course, there are a few withdrawal exceptions that help you sidestep the withdrawal penalty. These include:

1. Death or disability.
2. A payment plan of “substantially equal payments” over your lifetime.
3. Medical expenses that are non-reimbursed, and total over 7.5% of your annual income.
4. Medical insurance (under special circumstances only).
5. Qualified higher-education expenses.
6. Home purchase or renovation up to $10,000. 

However, if you are nearing retirement, you should know that while you qualify to take withdrawals from your SEP IRA at age 59 ½, you aren’t required to take them until age 72. This can help you extend the life of your savings, especially if you plan to continue working (and contributing) beyond age 59 ½. 

Rolling Over Your SEP IRA

If for some reason you join a company or stop earning self-employed income, you can roll your existing SEP IRA over to a Traditional IRA tax-free. 

Can You Contribute to Other Retirement Accounts and Your SEP IRA?

In a word – yes! Whether you have access to a Traditional or Roth IRA, or a workplace retirement account like a 401(k), you can continue to contribute to your other retirement savings accounts. However, if you’re planning to contribute to both a personal IRA and your SEP IRA, you may be limited when it comes to how much of your contributions you can deduct.

Having access to a SEP IRA means that, technically, you’re covered by an employer-sponsored retirement plan. This reduces the total income limit that allows you to deduct Traditional IRA contributions to $65,000 (single) or $104,000 (married filing jointly). 

When Would a SEP IRA Be a Good Fit For You?

If you’re a solopreneur or a small business owner with no other W2 employees, a SEP IRA is something you should absolutely explore. When you only have yourself to worry about, taking the deduction and funneling a large percentage of your earnings toward retirement is often a good financial move. 

This is especially true if you’ve spent a number of years as a freelancer or solopreneur without contributing toward retirement. Self-employed women, in particular, need to be thinking ahead when it comes to funding their retirement. Studies have shown that self-employed women face a 28% wage gap when compared to their male peers

Having a potentially lower income from the onset of your self-employment journey can negatively impact your ability to save effectively for retirement. This is true both because there’s less total income to contribute toward your retirement savings goals and because there’s often a lack of willingness to part with income because of other, seemingly more pressing, financial obligations.  

Combine that with the fact that only 6 out of every 10 self-employed individuals have retirement savings, and female entrepreneurs are at a notable disadvantage when it comes to building a nest egg for retirement. This makes the concept of a SEP IRA even more attractive to female entrepreneurs who are needing to play a bit of “catch up” with their retirement savings.

Setting Up Your SEP IRA

A SEP IRA is relatively easy to set up. You start by creating a SEP plan with a written agreement. The government even has an agreement template for you to get started

If you’re the only qualifying employee at your company, you can move forward with setting up your very own SEP IRA through a financial institution of your choice. If you have employees, you’ll need to distribute a copy of the SEP plan agreement you’ve written, and make sure they each open their own SEP IRA, and choose their own investments.  

Need help? Reach out to our team! Our team specializes in working with breadwinning women and entrepreneurs and would love to help you start making empowered decisions about your retirement savings.

The post What’s a SEP IRA and How Does it Work? appeared first on Workable Wealth.


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