Introduction

A SEP IRA (Simplified Employee Pension IRA) is a straightforward employer‑funded retirement plan built for small businesses and self‑employed people who want employer contributions without the paperwork of a full-featured 401(k). Unlike SIMPLE IRAs or 401(k) plans, SEP contributions are made by the employer only; employees don’t make salary deferrals. The plan’s simplicity and relatively high contribution potential make it a popular first choice for small employers, but it isn’t always the best fit depending on objectives like employee recruitment, employee contributions, or nondiscrimination testing requirements.

How SEP contributions work (and common calculation pitfalls)

  • Employer-only contributions: Employers decide whether to make a contribution each year and must use the same percentage of compensation for all eligible employees in that year (unless different classes of employees are properly excluded by plan rules permitted by the IRS).
  • Contribution limits change annually: Recent years illustrate the indexing — the limit was $66,000 in 2023 and rose to $69,000 in 2024. The IRS updates limits annually, so check current-year figures before planning (IRS Retirement Plan FAQs regarding SEPs).
  • Self‑employed calculation: If you’re self‑employed, the contribution is calculated on net earnings from self‑employment after deducting half of the self‑employment tax and the SEP contribution itself. Practically, a “25% of compensation” limit for employers translates into an effective rate of about 20% of net self‑employment income for a sole proprietor or partner. Mistakes here cost either missed contributions or filing corrections.

Plan setup, administration and deadlines

  • Easy setup: Establishing a SEP is as simple as executing Form 5305‑SEP (if using a prototype plan without a separate trust) and giving eligible employees a notice. An employer can also adopt a SEP through a financial institution’s paperwork (custodial IRA documents).
  • Low annual administration: There’s no annual IRS Form 5500 filing for most SEPs, and no annual nondiscrimination testing, which reduces recordkeeping and plan costs compared with 401(k)s (Department of Labor guidance).
  • Contribution deadline: Employer contributions for a tax year can generally be made up to the employer’s business tax return due date, including extensions. That flexibility helps owners who want to fund a plan after seeing year‑end results (IRS SEP FAQs).

Key advantages of SEP IRAs

  1. Simplicity: Quick to set up and simple to maintain, with minimal paperwork relative to 401(k) plans.
  2. Flexible employer contributions: Employers can vary contributions year to year — contribute a high percentage in strong years and skip or reduce contributions in lean years (but if you contribute for owners, you must follow plan rules for eligible employees).
  3. High contribution potential: Employer contributions historically have been higher than SIMPLE IRA employee limits, making SEP attractive for owners who want to shelter income now. Because limits are indexed, the maximum dollar cap rises over time (see IRS updates).
  4. Tax benefits: Employer contributions are generally tax‑deductible to the business and grow tax‑deferred in employees’ SEP IRAs.

Limitations and tradeoffs

  • Employee contributions not allowed: Employees can’t defer salary into a SEP; that can be a meaningful drawback if you want staff to save through payroll deferrals. For employee‑driven saving, consider a 401(k) or SIMPLE IRA.
  • Required uniformity: When you make a contribution, the employer must follow the allocation formula in the plan — typically a uniform percentage of compensation to all eligible employees — which can increase costs for larger staffs.
  • No loans or Roth option: SEP IRAs don’t allow participant loans, and SEP contributions go into traditional IRAs (pre‑tax). If employees want Roth‑style tax treatment, the plan itself doesn’t provide it (though employees may later convert funds to a Roth IRA subject to tax consequences).
  • Vesting and matching features: SEP IRAs are employer contributions directly to IRA accounts, so typical 401(k) vesting schedules or matching arrangements aren’t applicable in the same way.

Comparing SEP IRAs with SIMPLE IRAs and 401(k) plans

SIMPLE IRA

  • Best when: You want both employer and employee participation in a low‑cost plan and you have 100 or fewer employees.
  • Employee contributions: Allowed via salary reduction (elective deferrals).
  • Employer commitment: Employer must either match employee deferrals up to 3% or make a 2% nonelective contribution for all eligible employees.
  • Administrative complexity: Slightly higher than a SEP because of required payroll deferrals and employer obligations.

401(k) (small‑business or traditional)

  • Best when: You want high employee contribution potential, allow loans, offer Roth 401(k) options, or provide selective employer matching that targets retention and benefits high‑performing employees.
  • Employee contributions: Allowed and typically the primary feature of the plan.
  • Employer options: Matching, profit‑sharing, discretionary contributions; subject to nondiscrimination testing unless using safe harbor design.
  • Complexity and cost: Higher setup and annual administrative costs, plus Form 5500 filings and possible testing. But advanced design (e.g., safe harbor, automatic enrollment) can improve retirement outcomes and employee uptake.

Examples

1) Solo business with variable income: A freelancer with inconsistent revenue may prefer a SEP because contributions are optional and can be large in good years without committing in lean years. In my practice, I’ve helped contractors make sizable year‑end SEP contributions to reduce taxable business income when cash flow allowed.

2) Small employer focused on retention: A small agency with multiple employees often chose a 401(k) with employer match because employee deferrals increase participation and are seen as a valued benefit, even though plan costs were higher.

3) Employer wanting employee deferrals but low cost: A business with <100 employees that wants a low‑cost structure but also wants employees to contribute may choose a SIMPLE IRA as a middle ground.

Coordination with other plans

  • Multiple plans: Employers and individuals can have more than one type of plan in play over time. An employer could maintain a SEP and still allow employees to contribute to an individual 401(k) or IRAs outside the employer plan, but overall contribution limits and tax rules must be observed.
  • Owner contributions across plans: If an owner also participates in a 401(k) or another employer plan, contribution limits interact. Always run the math or consult a plan advisor or CPA to avoid exceeding limits.

Common compliance and operational mistakes

  • Miscalculating self‑employed contribution percentages: The correct formula for owners is different than for W‑2 employees — using the simple “25% of net” without the self‑employment adjustments will overstate allowable contributions.
  • Treating SEP and SIMPLE as interchangeable: Each plan has specific eligibility, employer obligations, and reporting rules; choosing one without evaluating both short‑ and long‑term goals can cost money or employee goodwill.
  • Forgetting contribution deadlines: The ability to make contributions up to the business tax-filing date, including extensions, is a benefit — but missing recordkeeping steps or failing to timely notify employees of plan terms creates problems.

Practical checklist when deciding

  1. Determine goals: Maximize owner deductions now, increase employee participation, or provide predictable employer matches?
  2. Model costs: Include provider fees, payroll system changes, and potential employer contributions across all eligible employees.
  3. Check employee count and demographics: A plan that’s generous to owners may be costly if you have many long‑tenured employees.
  4. Consult a tax pro: Especially for self‑employed calculations and coordination with other retirement accounts.

Where to confirm rules and limits

  • Internal Revenue Service (IRS) — SEP FAQs and plan rules (search “IRS SEP IRA FAQs”).
  • Employee Benefits Security Administration (Department of Labor) — small business retirement plan guidance (EBSA).

In practice (professional insight)

In my 15 years helping small business owners choose retirement plans, SEP IRAs are often the correct first step for sole proprietors and very small partnerships because of the low administration and the flexibility of employer contributions. However, when a business reaches the point where employee recruitment and retention matter more, a shift to a 401(k) or a SIMPLE IRA frequently provides better long-term value despite higher costs.

Legal and advisory disclaimer

This article is educational and does not constitute personalized tax, legal, or investment advice. Plan rules and contribution limits change; consult your CPA, ERISA counsel, or plan provider and check the IRS and Department of Labor resources for the current year before implementing a retirement plan.

Selected further reading on FinHelp

Sources

  • IRS, Retirement Plans FAQs regarding SEPs (search IRS.gov for “SEP FAQs”).
  • U.S. Department of Labor, Employee Benefits Security Administration — Guidance for small businesses.

Professional disclaimer: The information here is general and educational. For plan design decisions and tax filing guidance, consult a qualified tax advisor or ERISA‑knowledgeable attorney.