SEP IRA Rules: What is a Simplified Employee Pension?

Retirement plans are limited by strict regulations, yet they still somehow manage to cater to many different investors. The simplified employee pension, or SEP, IRA stands out in particular by answering not only the needs of future retirees and the companies that employ them, but also accommodating entrepreneurs. Get informed to feel more confident about your portfolio choices.

What Is a SEP?

A simplified employee pension individual retirement arrangement, or SEP IRA, is a type of employer-sponsored retirement plan. To implement one, a company sets up a policy and informs its workers about the new terms. It then creates a traditional IRA account on behalf of each employee.

Like traditional IRAs, these plans allow you to make contributions tax free. You pay the IRS when you receive distributions, also known as withdrawals.

With traditional IRAs, the employee contributes their own pretax money. Roth IRA contributions happen after taxes, but the source is still the same — you. SEP IRAs, on the other hand, let the company contribute to the employees’ plans before taxes.

A salary reduction simplified employee pension plan, or SARSEP, is a rarer form of legacy SEP. These plans were established before 1997, and they involve employees reducing their salaries to contribute.

What is a simplified employee pension (SEP)?

Why save for retirement?

Putting money in some kind of IRA now could let you legally pay less income tax. For instance, if your tax rate rose in your retirement, then you might beat the system by taking tax-free Roth IRA distributions. If you had a lower tax rate while getting payouts as a retiree, then the IRS would take a smaller amount out of your SEP or traditional IRA withdrawal checks.

SEP IRA Rules on Eligibility

SEP IRAs include controls designed to make them fair. For instance, the IRS defines the standards by which employees are deemed eligible for SEP participation. Although employers can use more lax requirements, their SEP plans have to accept any employees who

  • Have been employed by the company for at least three out of the last five years,
  • Got paid at least $600 in compensation from the company during the year, and
  • Are 21 years old.

These SEP IRA rules make the retirement plans accessible to a broad cross-section of the working population. For instance, a recent college grad who worked for two years as a part-timer while they were in school and then came on full-time would meet the standards. So would someone who opened her own business and wanted to set up a retirement plan designed to suit her personal investment strategy.

Employer Participation

Companies with SEP plans have the option of electing not to contribute under certain circumstances. For instance, a firm’s SEP contract might include a clause saying that it will not contribute during years when its organizational profit margin falls below a certain percentage.

The Outlook Ahead for SEPs

The Investment Company Institute reported that in 2010, only 9.6 million of the 46.1 million households that owned IRAs owned SEP IRAs, the older SARSEPs or SIMPLE IRAs. At the same time, these investments still accounted for billions of dollars’ worth of retirement assets. With more small companies wanting straightforward, equitable retirement plans, SEPs may become even more common nest egg assets in the near future.

What is a simplified employee pension plan definition?

How is a SEP defined?

A SEP retirement plan is not meant to benefit some workers to the exclusion of others. The law ensures that these retirement programs treat all employees as equally as possible. For instance, companies that create and operate SEP plans also need to

  • Amend their policies yearly to meet current laws,
  • Provide contributions for all eligible employees, and
  • Stay below the annual contribution limits.

Other fairness rules include regulations designed to prevent employers from playing favorites. For instance, all compensation-based contributions to simplified employee pensions must be determined using predefined formulas that cover bonuses and commissions. Companies are also prohibited from contributing higher compensation percentages to individual employees’ plans and lower rates to their coworkers’ plans.

Limits and Contributions

SEP IRA retirement accounts include yearly contribution limits. For instance, if you are your own boss, then you can contribute the lesser of 25 percent of your income or $56,000. This generous limit applies even if you own other inherited retirement accounts or work another job for someone who maintains a different retirement plan on your behalf. The limits are also the same for companies that contribute to their workers’ SEP IRAs.

How do SEP IRA rules on contribution calculations work?

Contributions are percentage based. They amount to a specific fraction of your income, and under the law, up to $280,000 of income is eligible to be counted.

When Can Contributions Occur?

SEP IRA contributions are also time-restricted. They share their deadline with another big occasion — Tax Day.

An employer can make SEP IRA contributions for a given year until the following April 15 filing deadline. If you wanted to make contributions for 2021, you would have until April 15, 2022. If you filed an extension, you could extend your effective SEP IRA contribution deadline by putting your tax return off until October 15, 2022.

Contributions and Distributions

SEP IRA rules mostly focus on your investment money when it is in one of two forms: a contribution or a distribution.

Tax Deferred-Contributions

A SEP is a plan where your employer makes compensation-based contributions before income taxes. Since the contributions does not get included in your gross income, you do not assume any additional burden. Since you end up paying later, however, the money counts as tax-deferred, and the benefits persist even if you take an active role in managing your portfolio in the interim.

Taxable Distributions

Almost all distributions taken from a simplified employee pension will carry an income tax burden. In most cases, this will be determined by your tax bracket during the year the withdrawal occurred. In certain situations, however, you might be assessed an extra tax penalty.

distribution penalties for a simplified employee pension

SEP IRA Rules on Distribution Penalties

Many investors make the mistake of taking their simplified employee pension distributions at inappropriate times. As with traditional individual retirement accounts, some unapproved withdrawals carry an extra penalty. You will owe ten percent more income tax than whatever you already have to pay.

Guidelines and Exceptions

The biggest offense to avoid is taking an early distribution. The IRS penalizes you for receiving money from an individual retirement account before reaching the age of 59½. There are, however, a few exceptions to the traditional and SEP IRA rules:

Unreimbursed Medical Expenses

You can pay certain medical expenses that you will not be compensated for, including your insurance premiums while you are between jobs. Your medical bills have to exceed 10 percent of your AGI. You only get to withdraw the difference between the bill and 10 percent of your AGI before being penalized.

For a Disability

If you are totally and permanently disabled, you can take withdrawals. This means having a disability that prevents you from working to support yourself.

As a Beneficiary

If you inherit a SEP account after its original owner dies, then you will not get penalized for taking early distributions from it. This makes it easier to save for retirement as an heir.

As Part of a SEPP

A series of substantially equal periodic payments, or SEPP, is a payment plan that lets you take penalty-free early distributions. The withdrawals have to be spread out over at least five years or until you are 59½ years old.

For Qualified Higher Education Expenses

Costs such as college tuition and student fees can be paid using an individual retirement account without taking on a penalty. The expenses have to satisfy the IRS’ strict standards and occur in the same tax year as the distributions, however.

To Purchase a First Home

You can withdraw up to $10,000 to pay for a home. You are eligible if the property is going to be the first home that you have owned in the past two years.

To Pay an IRS Levy

The IRS might levy, or seize, your property to deal with outstanding tax debts. If they come for your simplified employee pension money, you will not be double-fined as if you had taken an early distribution.

Required Minimum Distributions

If you decide to put your retirement off, be ready to adjust your nest egg nurturing strategy accordingly. SEP IRA rules follow in the footsteps of traditional retirement accounts by forcing you to take distributions once you reach age 70½.

These withdrawals are known as required minimum distributions, or RMDs. Many effective retirement strategies work by transferring, or rolling over, RMDs into rollover retirement accounts, such as Roth IRAs.

What are the advantages of a simplified employee pension?

Companies and investors like simplified employee pensions for many different reasons. To a worker, it might be easier to get help saving for retirement without having to do all of the legwork. For an employer, being able to claim a tax deduction is often more than reason enough to start a plan.

Starting a simplified employee pension is a good way to give workers flexible nest eggs. Like other IRAs, these plans lend themselves to straightforward portfolio management and investing. They also cost little to administer, making them ideal for smaller enterprises.

Are there SEP disadvantages?

SEP plans may not be perfect for every company. Small startups that lack the income to contribute consistently may disappoint employees who joined up in the hopes of receiving good benefits.

Since companies have to contribute the same compensation percentage to each employee, they need to ensure they have the revenue to foot the bill. If they exceed the contribution limits, then their employees may have to pay a 6 percent excise tax. They can avoid it, however, by withdrawing the excess and earnings before that year’s tax return due date.

A simplified employee pension compared to other IRA plans

Comparisons to Other IRA Plans

A simplified employee pension is backed by traditional individual retirement accounts. This means that the traditional and SEP IRA rules overlap heavily. Again, the primary difference lies in where the contributions are coming from.

Things are a bit different with Roth IRAs. Roth IRA contributions come from your private bank account, so the money has already been taxed. When you make a valid withdrawal, you will not have to pay again.

What about 401(k)s? These plans are similar to simplified employee pensions because they are employer funded. They have different limits, however. As defined-contribution plans where employees save fixed percentages of their paychecks and get employer matching, 401(k)s include a number of withdrawal restrictions.

Which companies might start SEP retirement plans?

SEP plans are perfect for organizations that have hit the sweet spot of startup growth. These freelancers, sole proprietors and small companies are making enough money to think about the future and investing in their workforces is a good start.

This form of employer-driven retirement planning might also appeal to companies that want to save time and simultaneously cut their costs. A SEP IRA is a low-cost way to manage numerous retirement accounts. The minimal setup and maintenance costs ultimately mean that more of the money goes toward the intended goal of keeping the beneficiary comfy in their old age. The contribution limits are also relatively high at 25 percent of an employee’s compensation or $56,000.

Which companies should start 401(k)s?

These plans are workable for businesses of any size. It should be noted, however, that they cost more to set up and maintain. They also curb your annual contributions more drastically — If you’re under 50 years old, you can save $19,000 for retirement each year, and if you are older, then the limit is $25,000 annually.


A savings incentive match plan for employees, or SIMPLE, individual retirement account is another tax-deferred profit-sharing plan type. It caters to companies with 100 or fewer employees by offering low maintenance costs. Its contribution limits, however, are quite small compared to the SEP limits — $13,000 per year for those under 50 and $16,000 annually for those older. Also, individual contributions are not tax-deductible.

Terminating a SEP Plan

Companies can also terminate their simplified employee pensions. They might do so for various reasons, such as when they switch to different kinds of retirement planning strategies. Fortunately for workers, the money in the plans is still theirs, although they may want to roll their assets over into accounts with more permissive laws than the SEP IRA rules.

Creating, Operating and Maintaining a Plan

Starting a plan as an employer is a surprisingly straightforward task. After drafting your plan using Form 5305-SEP or a prototype document from a bank or mutual fund as a model, you will verify that your terms satisfy the standard SEP IRA rules of eligibility and let your employee-beneficiaries know about the new program. Next, you can create retirement accounts and start contributing.

Each year, you will need to update your simplified employee pension policy to meet IRS guidelines. This process includes things like making sure you have covered all the right employees, confirming that you are paying the correct percentages and ensuring that your paperwork clearly explains all the details. You also need to report contributions using Form 5498.

Do the Smart Thing With Your Simplified Employee Pension

What is a SEP  going to do for your future? While the outcome partially depends on your role as the employer sponsor or employee, your ability to pick the right investment tools also matters.

Managing the individual retirement account behind your simplified employee pension, deciding when to roll funds over and staying on top of the tax rules are all big jobs. You need powerful investment tools that make it easy to run your portfolio from anywhere.

M1 makes investing transparent without fees or commissions so that you can manage your SEP IRA retirement accounts for improved growth. Its AI-powered advisements and smart dashboards give you the perspective to pick investments in real time. Dynamic rebalancing and custom portfolio composition tools that work from your smartphone mean that no matter how your retirement planning practices evolve or how busy your life gets, you will have the means to chart out a roadmap  anytime, anywhere.

What is a SEP IRA good for if you cannot put the money to productive use? Learn how today’s wealth-builders are transforming their relationships with their personal finances by signing up today.