How a simplified employee pension (SEP) IRA works

A Simplified Employee Pension IRA (or SEP IRA) is a retirement savings plan established by employers – including self-employed individuals – for the benefit of their employees or themselves. Employers may make tax-deductible contributions on behalf of eligible employees to their SEP IRAs.

SEP IRAs also have higher annual contribution limits than standard IRAs. Fundamentally, a SEP IRA can be considered a traditional IRA with the ability to receive employer contributions. One major benefit it offers employees is that employer contributions are vested immediately.

According to Internal Revenue Service (IRS) rules as of 2018, an individual must be at least 21 years old, have worked for the employer in at least three of the previous five years and have received a minimum of $600 in compensation from the employer during the current year to qualify for an employee SEP IRA. Individual employers are allowed to be less restrictive in their qualification requirements for their specific SEP IRA plans but may not be more restrictive than IRS rules.

Certain types of employees may be excluded by their employer from participating in a SEP IRA, even if they would otherwise be eligible based on the plan's rules. For example, workers who are covered in a union agreement that bargains for retirement benefits can be excluded. Workers who are nonresident aliens can also be excluded as long as they do not receive U.S. wages or other service compensation from the employer.

Not all businesses can start SEP IRAs, which were primarily designed to encourage retirement benefits among businesses that would otherwise not set up employer-sponsored plans. Sole proprietors, partnerships and corporations can establish SEPs.

A SEP IRA is an attractive option for many business owners because it does not come with many of the start-up and operating costs of most conventional employer-sponsored retirement plans. Many employers also set up a SEP plan to contribute to their own retirement at higher levels than a traditional IRA allows.

SEP IRA accounts are treated like traditional IRAs for tax purposes and allow the same investment options. The same transfer and rollover rules that apply to traditional IRAs also apply to SEP IRAs. When an employer makes contributions to SEP IRA accounts, it receives a tax deduction for the amount contributed. Additionally, the business is not "locked in" to an annual contribution – decisions about whether to contribute and how much can change each year.

The employer is not responsible for making investment decisions. Instead, the IRA trustee determines eligible investments and the individual employee account owners make specific investment decisions. The trustee also deposits contributions, sends annual statements and files all required documents with the IRS.

As of 2019, contributions cannot exceed the lesser of 25% of the employee's compensation for the year, or $56,000 (up from $55,000 in 2018). This is significantly higher than the $6,000 limit imposed on standard IRAs (not including the extra $1,000 those age 50 or over are permitted as a catch-up contribution). The deadline for contributions is the tax filing deadline (plus extensions) of the company or self-employed individual who sets up the SEP IRA.