SEP IRA Guide: A Simple Owner Retirement Plan and Its Trade-Offs

The Simplified Employee Pension (SEP) IRA earns its reputation for simplicity. It can be opened in an afternoon, has minimal paperwork, and lets an owner decide each year how much to contribute, including nothing. Its main trade-offs are the lack of an employee deferral component and the employee coverage rule.

How it works

A SEP is an individual retirement account set up by an employer for each eligible employee, including the owner. Only the employer contributes (employees cannot defer their own salary into a SEP, except in older arrangements that are no longer available). Contributions are deductible to the business, and money grows tax-deferred until withdrawal. Contributions are immediately vested.

Who can use it

Any business can establish a SEP, including sole proprietors, partnerships, LLCs, and corporations. The plan can be used by businesses with or without employees. That flexibility makes it a common first plan.

Contribution limits

The maximum employer contribution for a year is the lesser of:

25 percent of the employee's compensation, or
The annual dollar limit (for 2025, $70,000), subject to the compensation cap for plan purposes ($350,000 in 2025).

These figures adjust annually, so verify current numbers.

For an S-corp or C-corp owner, compensation means W-2 wages. For a sole proprietor or partner, compensation is net earnings from self-employment after deducting one-half of self-employment tax and the SEP contribution itself. The circular calculation means the effective maximum rate for a self-employed person is about 20 percent of net earnings before the adjustments. Use the IRS worksheet in the SEP instructions.

Deadlines

A SEP can be established and funded up to the business's tax return due date, including extensions, for the year for which the contribution is made. That is a helpful late-in-the-game option for owners who realize after year end that they need a deduction. Compare with a solo 401(k), where employee deferral timing is tighter. See solo 401(k) guide.

Contributions for the year must be made by the filing deadline (with extensions) to be deductible for that year.

The employee rule

If you have eligible employees, you must contribute the same percentage of compensation for them as you do for yourself. Eligible employees generally are those who are at least 21, have worked for you in at least three of the last five years, and have earned at least a set amount of compensation in the year (with an indexed threshold). You can use less restrictive eligibility rules, but not more restrictive ones than these.

So if you contribute 20 percent of your pay, you must contribute 20 percent of each eligible employee's pay. For a business with several employees, that makes a SEP expensive. It also means owners who plan to hire should consider that before adopting a SEP. Alternatives include the SIMPLE IRA, a 401(k) with safe harbor design, or a plan with a different formula. Owners with no employees, or who use only independent contractors properly classified, can use a SEP without this concern. See contractor vs employee.

Roth options

Recent legislation allowed SEP and SIMPLE plans to offer Roth contributions, but adoption by providers has been gradual. Confirm whether your provider supports a Roth SEP option.

Setup steps

Complete IRS Form 5305-SEP (a model agreement) or a prototype SEP plan document from a financial institution.
Open a SEP IRA for yourself and each eligible employee.
Provide required information to eligible employees.
Make contributions by the deadline.
Keep records of the plan and contributions.

Unlike qualified plans, a SEP generally does not require annual IRS filings like Form 5500, which is one of its selling points.

Advantages

Easy setup and low cost.
Flexibility: contribute different amounts each year, or skip a year.
Late funding: can establish and fund up to the tax filing deadline.
High limit compared with many alternatives for those with substantial income.
No annual reporting in most cases.

Disadvantages

No employee deferral, which means lower savings potential than a solo 401(k) for modest incomes.
Employee coverage cost if you hire.
No loan feature.
Limited Roth options historically.
Contribution based on compensation, with S-corp owners limited by W-2 wages.
Interaction with the backdoor Roth IRA strategy: SEP IRA balances count toward the pro rata rule when converting traditional IRA money, which can complicate backdoor Roth conversions. Owners who use that strategy should consider it before opening a SEP.

Comparing with a solo 401(k)

For an owner with no employees, a solo 401(k) usually allows higher contributions at lower income levels, and offers Roth and loan features, while a SEP is simpler and offers the late-establishment convenience. See solo 401(k) vs SEP IRA for a head-to-head comparison.

Common mistakes

Adopting a SEP without considering employees.
Miscalculating the self-employed contribution. The 25 percent applies to reduced compensation, not raw net profit.
Contributing based on S-corp distributions rather than wages.
Missing the contribution deadline.
Contributing to an IRA account that is not a SEP-IRA and failing to document the plan.
Forgetting the aggregate limits with other plans.
Overlooking the pro rata rule effect on Roth conversions.
Excluding eligible employees improperly.

Reporting the deduction

For self-employed individuals, the SEP deduction goes on Schedule 1 of Form 1040. For S-corp and C-corp businesses, the contribution is an employer deduction on the entity return, with the amount not included in the employee's W-2 wages. See S-corp tax return guide.

If you are weighing a SEP against other plans, AE Tax Advisors can help you model the choices, and a discovery call is a good first step.