Who is eligible for a SEP IRA?

The reason the word “simplified” is in the name of a SEP IRA is specifically because it provides a relatively straightforward, tax-deferred method for self-employed people (like freelancers or those with side gigs) and small business owners to contribute to their own retirement as well as their employees’ retirement savings.

For those who don’t have an employer-sponsored retirement plan like a 401(k), it’s an incentive to save for your future.

Any business owner, or anyone who earns freelance income, can contribute to a SEP-IRA. If you have others working for you, they’re also eligible for a SEP IRA (as outlined by the IRS) if they:

  • Are at least 21 years of age or older.

  • Have worked for your company for any three of the last five years. (It’s referred to as the “3-of-5 rule.”)

  • Earn at least $600 for that calendar year.

One thing to note: If an employer has employees who are eligible to participate in their SEP IRA plan, that employer has to contribute on their employees’ behalf—not just their own. So if you’re planning on putting 18 percent of your salary toward your SEP IRA, you also have to contribute 18 percent of your employees’ salaries to their plans.

For that reason, SEP IRAs make the most sense for those who run a small business with very few employees (think five or less) or self-employed people who just need to worry about their own finances. Employers get tax deductions on the contributions they make while employees aren’t taxed on those contributions until they eventually withdraw their contributions. (If you’re self-employed, you can also take a deduction, but you need to make a “special computation,” as the IRS puts it, to figure out your maximum deduction for these contributions. (The IRS offers instructions.)

How do you set up a SEP IRA?

Establishing a SEP IRA is relatively easy.

If you’re self-employed, after you choose an account provider through a brokerage or a bank, you need to fill out a Form 5305-SEP (or Simplified Employee Pension Individual Retirement Accounts contribution agreement) or complete an IRS-approved plan form through the account provider. (Acorns customers can set up a SEP IRA through Acorns Later.)

If you have eligible employees, there are three steps you need to take, as outlined by the IRS:

  1. Establish a formal written agreement via the IRS Form 5305-SEP or through the account providers.

  2. Provide eligible employees with information about the SEP IRA, either with a copy of the IRS Form 5305-SEP or details from the account provider.

  3. Set up SEP IRAs for eligible employees with your chosen account provider. The employees own and control their own SEP IRA account.

How much can you contribute?

Where a traditional IRA is relatively limited in the amount you can contribute—up to $6,000 in taxable income in 2020 or $7,000 if you’re 50 or over—a SEP IRA allows you to contribute a hefty chunk of your income. In 2020, you can contribute up to $57,000 or 25 percent of your salary, whichever is less. The 25 percent compensation limit is capped at $285,000 (up from $280,000 in 2019). If you’re self-employed, you use a special rule to calculate retirement plan contributions for yourself.

With a SEP IRA, most or all of your contributions are tax-deductible and you won’t pay taxes until you withdraw the money from your SEP IRA once you retire. You need to start taking minimum withdrawals at age 72. If, for whatever reason you decide to withdraw some of your money before you’re 59 ½, you’ll generally pay regular income taxes and receive a 10 percent penalty.

There are certain exceptions to this rule. For instance, if you withdraw up to $10,000 to buy your first home, or use the money to cover qualified educational expenses or qualified unreimbursed medical expenses, you can avoid the withdrawal penalty. However, you’ll still have to pay taxes on your withdrawals. Plus, you’ll lose out on the investment gains you would’ve earned.


What are the pros and cons of a SEP IRA?


Below are the pros of an SEP IRA: 

You can save a lot

One of the biggest appeals about a SEP IRA is the high contribution limit (up to $56,000), which can really make a difference in saving for your future. In 2020, the contribution limit for a 401(k) is $19,500 ($26,000 if you’re age 50 or older). You can also combine your SEP IRA with a traditional IRA or Roth IRA.


SEP IRAs are easy to set up and administer.


If a business or self-employed individual has a financially rocky year, the business owners are not required to make contributions for themselves or their employees.

Varied investment options

With SEP IRAs (as with other IRAs), you can diversify your investment options in stocks, bonds, index funds or other assets your brokerage provider or bank offers.

Advantageous for freelancers

Even if you have a full-time gig with a 401(k), if you have a lucrative freelance business on the side, you can save even more for retirement while getting tax deductions by investing in a SEP IRA.


Below are the cons of a SEP IRA: 

Expensive contributions

As an employer, if you contribute to your SEP IRA for yourself, you also have to make a proportional contribution for your eligible employees. That’s why SEP IRAs make the most sense for smaller businesses with fewer employees.

Immediate vesting

This can work against an employer who can typically benefit from a vesting schedule to discourage employees from jumping ship early. Conversely, it benefits the employee.

No catch-up contributions

For an employee who’s 50 or older, you don’t have the opportunity to make catch-up contributions (additional contributions beyond the established limit) like you can with a 401(k) or certain IRAs.

Age-related minimum distributions

Like 401(k)s and traditional IRAs, you’re required to begin taking minimum distributions at age 72.

Withdrawal restrictions

Unlike a Roth IRA, which allows you to withdraw your contributions at anytime without being penalized, withdrawing money from a SEP IRA before age 59 ½ will typically incur a 10% penalty, plus you’ll pay regular income taxes on it.

How do you invest with a SEP IRA?

Once you open your SEP IRA account, you determine how your investments are allotted. Having control over how your money is invested is one of the benefits of the SEP IRA.

You’ll want to take into consideration your age, when you hope to retire and how risk-averse you are. A good rule of thumb for any retirement account is having a diversified portfolio so that you can vary your investments while managing your risk.

Experts recommend that the closer to retirement you are, the less risky you’ll want your asset allocation to be. Bonds are on the more conservative end while stocks come with a greater risk—but also a potentially greater reward.

Where you are on your journey to retirement will play a major role in how you divvy up your SEP IRA investments so that you set yourself up for future financial success.

Investing involves risk including loss of principal. This information is presented for educational purposes only and is not a recommendation to buy or sell a specific security or engage in a particular strategy. This information is being provided for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. You should consult your tax or legal adviser regarding such matters.