SEPs are popular with small businesses because they can be simpler to administer than many qualified retirement plans while still allowing substantial employer contributions.
Key Takeaways
- Employer-funded structure: Traditional SEP arrangements generally do not use ordinary employee salary deferrals.
- Immediate ownership: SEP contributions are 100% vested when made.
- IRA-based accounts: Each participant holds a SEP IRA at a financial institution and generally controls the investments.
- Flexible annual funding: Employers can often decide whether to contribute from year to year, subject to plan and nondiscrimination rules.
How a SEP IRA Works
An employer adopts a SEP arrangement and contributes to IRAs established for eligible employees. Self-employed individuals can act as both employer and participant for this purpose.
Once contributions reach the employee’s SEP IRA, the employee generally chooses among the investments available at the financial institution.
Who Makes the Contributions?
Under a standard SEP, contributions are made by the employer rather than through employee elective salary deferrals. Older grandfathered SARSEP arrangements follow different rules.
Federal SEP rules generally cap employer contributions at the lesser of a percentage of compensation or the annual dollar ceiling, with special calculations for self-employed individuals.
Employee Eligibility and Equal Treatment
Employers can set eligibility criteria within federal limits, but qualifying employees generally must be covered when the plan’s conditions are met. SEP contributions generally must use a uniform relationship to compensation for covered employees.
This can make a SEP less attractive for an owner with several eligible employees because contributing a high percentage for the owner can require comparable percentage contributions for employees.
SEP IRA vs. Traditional IRA
| SEP IRA | Traditional IRA |
|---|---|
| Employer retirement arrangement funds the account | Individual generally makes personal IRA contributions |
| Uses separate SEP contribution limits | Uses annual individual IRA contribution limit |
| Can coexist with personal IRA contributions | Deductibility can depend on income and workplace-plan coverage |
An individual can have both a SEP IRA and make a separate traditional or Roth IRA contribution when eligible under the respective rules.
Vesting and Investment Control
SEP contributions are always 100% vested. An employer cannot impose a multi-year vesting schedule on money already contributed to the employee’s SEP IRA.
Because the account is an IRA, participant loans are not permitted.
Immediate vesting also means an employee keeps prior SEP contributions after leaving the employer, although future employer contributions stop unless the worker remains eligible under the arrangement.
Withdrawals, Rollovers, and RMDs
Withdrawals from traditional SEP IRAs generally follow traditional IRA tax rules. Taxable distributions are included in income, and early distributions can trigger an additional tax unless an exception applies.
SEP assets can generally be rolled to eligible IRAs or retirement plans. These accounts are also subject to required minimum distribution rules.
Roth SEP Contributions
Current federal law permits SEP arrangements to allow Roth treatment for qualifying contributions when the plan and provider support it. Roth SEP contributions follow Roth tax principles rather than traditional pre-tax treatment.
Availability is operationally dependent on the employer’s arrangement and financial institution rather than automatic for every SEP.
Why Businesses Use SEPs
SEPs generally have limited employer filing requirements and can be established using standardized documents. That simplicity can appeal to sole proprietors and small employers with variable profits.
The main tradeoff appears when several employees are eligible: a generous contribution percentage for the owner generally requires comparable treatment for covered employees, which can make the plan more expensive.