What is it?
Created in 1978, the SEP IRA (short for Simplified Employee Pension Individual Retirement Account) is widely regarded as one of the best small business retirement accounts. The popularity of the SEP is mainly due to its ease of use, low operating cost, “high” contribution limit, and flexible discretionary contribution rules.

Creating a SEP IRA
One of the grandest and most unique positive attributes of a SEP is that the account does not have to be set up until the extended due date of the employer’s tax return. This means that if an employer files a valid extension it has until 9/16/2019 (10/15/2019 for sole proprietors) to create and contribute to a SEP and deduct the contribution on the 2018 tax return. There are multiple variations of SEPs but for the vast majority of employers a model SEP IRA1 will be used and is created by filling out Form 5305-SEP. SEP IRA accounts can be easily set up with many custodians with no setup fee. There are no additional annual filing or reporting requirements outside of providing annual disclosures to all eligible employees.

All contributions into SEP IRAs are made by the employer, meaning, unlike many other retirement plans, employee deferrals are not allowed. Employers are able to contribute up to 25% of employee compensation (or up to 20% of self-employed net earnings for non-employee owners) up to a cap of $55,000 for 2018 ($56,000 for 2019). Compared to the maximum contribution limit for Traditional and ROTH IRAs of $5,500 in 2018 ($6,000 for 2019) the SEP IRA drastically increases the rate at which an individual can build their retirement savings.

SEP IRA contributions are discretionary, leaving the employer to decide each year if it wants to make contributions or not. This flexibility is yet another reason for the high adoption rate of SEP IRAs. If the business did not perform as expected, the employer has the unanimous right to discontinue any SEP IRA contributions it was historically making. While the decision to make contributions is at the discretion of the employer, to whom those contributions are made is out of the employer’s hands for the most part. In a year where an employer is making SEP IRA contributions, each eligible employee must receive a contribution as set out in Form 5305-SEP. While a SEP IRA offers different participation standards for employers to choose from, generally an eligible employee is (1) at least 21 years of age at year end, (2) earned more than $600 of income during the year, and (3) has performed some service for the employer in 3 out of the previous 5 years. The employer has the ability to set the percentage (up to 25%) of compensation (capped at $275,000) that will be contributed each year but that percentage must be the same for every eligible employee under the model SEP IRA. For employers with numerous eligible employees this can be a rather expensive proposition.

It is important to recognize that the 3 out of 5 years of service requirement is not speaking of full time service. For example, if you hired a college student to count inventory for the last 3 years and paid him or her $200 each year and this year you hire the student for the summer and pay him or her $5,000, they would be entitled to a SEP IRA contribution if over the age of 20 in the current year. For reasons such as this, SEP IRAs are generally best suited for employers with few or no employees, or employees who typically do not work for longer than 3 years.
All contributions to SEP IRAs are 100% immediately vested and cannot have any withdrawal restrictions. This is typically viewed as a downside for employers as it does not encourage longevity of employees like a qualified plan vesting schedule could.

Distributions from SEP IRAs, much like Traditional IRAs, are taxable as ordinary income when distributed from the account and could potentially be subject to a 10% early withdrawal penalty if distributed before the age of 59 ½ without a qualifying exception. One benefit the SEP IRA has over a Traditional IRA is that once you reach the age of 70 ½ you can continue to receive SEP IRA contributions from your employer (which might happen to be yourself) as long as you are still working. With life expectancy increasing, and many seniors continuing to work later in life, this ability could be appealing to continue to build tax advantaged retirement savings even above the age of 70 ½. Keep in mind that this rule is only for contributions. The required minimum distribution rules still apply to SEP IRAs at age 70 ½ regardless of employment status.

Coordination with other retirement plans
Another important point to consider is how SEP IRAs interact with other retirement plans. There is no rule preventing an employer from having two retirement plans such as a 401(k) and a SEP IRA. The catch however is that there is an overall retirement account contribution limit per employee of $55,000 in 2018 ($56,000 in 2019) plus the catch-up of $6,000 if over 50. This limit is sometimes referred to as the 401(c) limit and acts as a cap on total contributions to an employee’s retirement plans with one employer or related employers. That being said, if an individual works for multiple unrelated employers, the individual could have multiple 401(c) limits. While the coordination of retirement plans is beyond the scope of this article, the takeaway is that an employer can have multiple retirement plans, but needs to carefully monitor to ensure overfunding does not take place.

Coordination with other businesses of the same owner
If an employer owns other businesses, either as a member of an affiliated service group, a controlled group of corporations, or as trades or businesses under common control, they cannot maintain a SEP IRA unless all eligible employees of all the members of such groups are covered. We typically see this where a business owner owns more than 50% of a business with employees who are either not covered by a retirement plan or are covered by a retirement plan with minimal employer contributions, and also has a wholly-owned sole proprietorship for which the employer wants to fully fund a SEP. The employer cannot fund the SEP without creating a funding obligation for the employees of the other controlled businesses.

In summary, the SEP IRA is a great tool for a number of employers. Such employers include those looking over the previous year wishing they had made a deductible retirement contribution in excess of $5,500. In addition, the SEP IRA is a great fit for employers who do not wish to lock into required annual retirement contributions. As you can see with the SEP IRA, flexibility is king and is often the reason for its wide spread popularity.


1 The model SEP IRA created by filling out Form 5305-SEP does have a few restrictions such as the employer must be a calendar year filer, must not already sponsor a qualified retirement plan, and must not be a member of a controlled group or businesses under common ownership unless all members of such group are covered under the SEP IRA. An alternative to the model SEP IRA is the prototype SEP IRA which can be created and sponsored by a qualified financial institution; however, the investments in such accounts are usually limited. An employer may also create an individually designated plan; however, establishing these plans usually becomes rather expensive requiring a private letter ruling approval from the IRS.