When to Use an SEP IRA

If you’re self-employed or you own a business with just a few employees, you already know that the key to your own retirement depends heavily on your ability to save your own money. After all, you don’t have a pension, nor do you have a company retirement plan to fall back on. You’re on your own.

Enter the SEP IRA, one of the best options for self-employed individuals and freelancers who want to save for retirement in a tax-advantaged way.

An SEP IRA is a qualified retirement plan that is available to businesses of any size. When we talk about “qualified retirement plans,” we’re talking about plans that receive special tax treatment from the government. SEP IRAs allow a business with one or more employees, self-employed individuals, and even freelancers the opportunity to take advantage of these special tax-deferred plans.

What is an SEP IRA?

An SEP IRA is a tax-advantaged retirement plan that can be opened up by employers of any size — even a business of one.

When an SEP IRA is used by an employer, the employer is allowed to make contributions to a traditional IRA opened in an employee’s name. Employers determine how much money is placed into the account based on a percentage of the employee’s income. This percentage can change from year to year, but the same percentage must be applied to all eligible employees.

When SEP IRAs are used by employers with several workers, those employees are not eligible to contribute to the plan. Employers make all of the contributions on their behalf, and employees are 100% vested from the moment the money is placed in the account. Contributions to an SEP IRA are held in a traditional IRA account under the umbrella of the SEP. This account is owned by the employee and is in his or her name.

SEP IRAs work similarly for self-employed workers, one-person businesses, and freelancers. When you’re self-employed and use an SEP IRA, you can contribute as little or as much as you can each year – up to the annual contribution limits, of course.

Since your contributions are tax deductible, the SEP IRA allows you to enjoy the same tax-advantaged benefits that regular workers take for granted. Meanwhile, much like with any other retirement account, the money grows tax-deferred until you’re ready to start taking taxable withdrawals in retirement.


As with any retirement plan, there are certain rules you must follow. Here’s a list of the rules regarding SEP IRAs:

  • Employer contributions only; no contributions from employees (self-employed SEP IRA owners act as the employer and employee)
  • Employer may not sponsor any other qualified retirement plans
  • Contribution limit of 25% of salary or $53,000 (whichever is less) for employees in 2015; contribution limit for self-employed people is 20% of net adjusted self-employment income
  • Contribution percentage is flexible and are not required each year
  • Each eligible employee must receive the same contribution percentage
  • Eligible employees must be 21 years old, have worked for the employer for three of the last five years, and surpassed the minimum level of compensation ($600 for 2015)
  • Employers can exclude a) employees whose retirement benefits were bargained for as a member of a union and b) nonresident alien employees who have not earned U.S. wages, salaries, or other personal services compensation
  • Withdrawals made prior to age 59 ½ are taxed as regular income and are subject to an additional early withdrawal penalty of 10%
  • Participants must begin taking required minimum distributions by age 70 ½
  • Catch-up contributions and elective deferrals are not permitted
  • Contributions must be deposited by due date for federal income tax return for the year
  • No “last-day-of-the-year” requirement for employment allowed

Highlights of a SEP IRA

  • Employer-sponsored
  • Available to any size business; excellent for self-employed workers and those with freelance income
  • Contributions are tax-deductible for employer
  • Money grows tax-deferred
  • Contribution limits are much higher than personal IRA accounts (25% of salary or $53,000 in 2015)
  • Can change contribution percentage on year to year basis
  • Employees are 100% vested
  • Can still contribute to a traditional or Roth IRA
  • Low administrative costs
  • Readily available through most online investment firms

Key Differences Between SEP IRAs and Other Retirement Plans

Although SEP IRAs work a lot like traditional retirement accounts, there are some distinct differences that make them advantageous to those with self-employed income.

The biggest advantage they offer is in how much money you can actually contribute. While the traditional and Roth IRA limits for 2015 are $5,500 ($6,500 for age 50 and older), the SEP IRA contribution limit for self-employed people saving in their own accountis set at 20% of net adjusted self-employment income up to $53,000. Meanwhile, SEP IRA contributions made by employers are capped at the lesser of 25% of the employee’s compensation or $53,000.

This helps employees and the self-employed set aside considerably more money for retirement than traditional IRAs allow. Even better, using an SEP IRA doesn’t preclude you from also contributing to a Roth IRA or traditional IRA – you can do both.

This is a huge advantage for freelancers like me. If I were to save for retirement in only a traditional IRA or Roth IRA, I would only be able to sock away $5,500 per year for retirement.

Meanwhile, the rules for using an SEP IRA are immeasurably simpler. When you use a traditional or Roth IRA for retirement, the rules become much more complex the more you earn. For example, married couples filing jointly with an adjusted gross income (AGI) between $183,000 and $193,000 cannot contribute the full amount to a Roth IRA. And those with an AGI over $193,000 can no longer use a Roth IRA as a retirement savings vehicle at all.

Similar rules affect those who use a traditional IRA. If your work offers a 401(k), for example, the deduction for your traditional IRA contribution is phased out completely if your AGI is $109,000 or more. If your workplace doesn’t offer a 401(k) but your spouse’s does, the tax deduction for your IRA begins phasing out at $167,000 and becomes phased out completely at $177,000.

None of these rules apply when you use a SEP IRA, and that’s part of the reason it’s such a good option. The table below illustrates the key differences and makes it easier to compare and contrast the most popular IRA options:

SEP IRATraditional IRARoth IRA
Annual Contribution LimitsFor Employees: 25% of all the employee’s compensation or $53,000, whichever is less
For self-employed workers:
strong> 20% of net adjusted self-employment income.
$5,500 ($6,500 over age 50)$5,500 ($6,500 over age 50)
Income Limits
Single or head of household: $131,000
Married, filing jointly: $193,000
Tax-deductible contributions
Yes, up to contribution limits.
Yes, but income limits apply if your employer (or your spouse’s) offers a 401(k).
Tax-deferred growth
Tax-free withdrawls in retirement
Withdraw contributions at any time without penalty
Penalty-free withdrawls to pay for first home or college

How to Open a SEP IRA

Opening an SEP IRA plan is relatively simple. Almost all online brokers offer SEP IRAs to their clients. In fact, my colleague Michael Gardon just opened his SEP IRA with TD Ameritrade, right before the tax deadline.If you’re self-employed, all you need to do is decide which firm you want to use to open your SEP IRA and begin the enrollment process.If you have employees in your business, you must complete three basic steps:

  1. Create a written plan and agreement stating your intent to offer retirement benefits to all eligible employees (even if you’re the only employee).
  2. Provide employees with information about the plan – including notice that you have created an SEP IRA, requirements for participation, and how the contribution is calculated.
  3. Create IRA accounts for each participating employee through your trustee.

Case Study: The Self-Employed Freelancer
An SEP IRA is an excellent tool for people who are self-employed or those who earn freelance or consulting income. The decidedly higher contribution limits allow you to save money at even higher limits than would be allowed by 401(k) plans at traditional workplaces.Contributions to the plan are usually 100% deductible, and the money grows tax-deferred. In addition, self-employed people are allowed to contribute up to the allowable limits on any traditional or Roth IRAs they may also have.Let’s take a look at how this could benefit somebody making a living with freelance income. For the purposes of simplicity, let’s assume this individual makes a net profit of $100,000 and does not receive their income through a W-2. Therefore, they’re subject to a contribution limit of 20% of net adjusted self-employment income. Here’s how it breaks down:

  1. Net profit: $100,000
  2. ½ self-employment tax deduction ($14,130): -$7,065
  3. Net adjusted self-employment income: = $92,935
  4. Reduced plan contribution rate: x 20%
  5. Allowable SEP contribution and deduction: = $18,587

Furthermore, this same freelancer would be allowed to contribute an additional $5,500 to their Roth or traditional IRA for a total of $24,087 in retirement savings for the year.While SEP IRAs are obviously beneficial for the self-employed, they are also great tools for small-business owners with few employees. The SEP IRA provides a company with a great amount of flexibility while keeping operating costs as low as possible. This is especially important for businesses with unpredictable cash flow. If the business has a good year, the business may contribute a higher percentage to the employees’ SEP IRAs than originally planned. During a bad year, the business can contribute whatever they can afford — or nothing at all.The Bottom LineWith the flexibility and distinct tax advantages SEP IRAs provide, it is no wonder they are one of the most popular retirement plans among the self-employed. The exceptionally high contribution limits make SEP IRAs a great tool for building a retirement nest egg, and the ability for contributions to fluctuate can be valuable for businesses or individuals with variable incomes.When you’re self-employed or own your own small business, it’s essential that you save for retirement in whatever way you can. So explore your options and open your new account without delay. The sooner you start saving, the better off you’ll be when you finally call it a day.

Holly Johnson

Contributing Writer

Holly Johnson is a frugality expert and award-winning writer who is obsessed with personal finance and getting the most out of life. A lifelong resident of Indiana, she enjoys gardening, reading, and traveling the world with her husband and two children. In addition to The Simple Dollar, Holly writes for well-known publications such as U.S. News & World Report Travel, PolicyGenius, Travel Pulse, and Frugal Travel Guy. Holly also owns Club Thrifty.