SEP IRAs Tutorial

A SEP is a retirement savings plan established by employers, including self-employed individuals (independent contractors- sole proprietorships or partnerships) for the benefit of their employees.

Employers may make tax-deductible contributions on behalf of eligible employees – including the business owner – to their SEP IRAs.

The employer is allowed a tax deduction for plan contributions that do not exceed the statutory limit.

SEP IRA contributions  are made to each eligible employee's SEP IRA on a discretionary basis. That means that the employer can choose to contribute (or not) each year. However, if the employer does contribute, it must contribute the same percentage of compensation to all employees eligible for the plan, up to the contribution limit. (For background reading, see What is the difference between a Roth, SEP and traditional IRA?)

Employees do not pay taxes on SEP plan contributions. However, distributions of these amounts plus any earnings are subject to income taxes.

An employee (including the business owner) who is eligible to participate in his or her employer's SEP plan must establish a traditional IRA to which the employer will deposit SEP contributions. Some financial institutions require the traditional IRA to be labeled as a SEP IRA before they will allow the account to receive SEP contributions. Others will allow SEP contributions to be deposited to a traditional IRA regardless of whether the IRA is labeled as a SEP IRA. Because the funding vehicle for a SEP plan is a traditional IRA, SEP contributions, once deposited, become traditional IRA assets and are subject to many of the traditional IRA rules, including the following:

• Distribution rules
• Investment rules
• Contribution and deduction rules for traditional IRA contributions. These apply to the employee's regular IRA contributions, not the SEP employer contributions.
• Documentation requirements for establishing an IRA. In addition to the documents required for establishing a SEP plan (discussed later), each SEP IRA must meet the documentation requirement for a traditional IRA.

(These rules are explained in the tutorial Traditional IRAs.)