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Simplified Employee Pension Individual Retirement Arrangement (SEP IRA)

June 26, 2019
Small Business

SEP IRA refers to the simplified employee pension individual retirement arrangement that can be established by an employer or a self-employed person to provide retirement benefits for themselves and their employees. The employer benefits from the tax deduction by contributing an employees pre-tax wages to the SEP individual retirement account..

Moreover, the other IRA plans don’t have higher contribution limitations as a SEP IRA. It distinguishes itself by solely accepting an employer’s contributions.

And employers can choose IRAs in 2019 from traditional IRA, simplified IRAs, SEP IRAs to Roth-oriented IRAs.

The purpose of seeking SEP IRAs is mostly because an employee wants to benefit the role as an employee and as well as an employer. Additionally, the amount of money an employer gets to add in a SEP IRA is not included in net income.. However, employees will have to deduct the contributed money from their income, which will lower their tax liability for that tax year.

For example, an individual with $80,000 income can make a contribution of $20,000 to a SEP IRA plan and would have to pay taxes on the remaining $60,000 income. And if your retirement year has a lower tax rate as compared to working years; it could help you save money on the paid taxes.

Although SEP IRA is a retirement savings plan, it has certain advantages that 401(k) don’t. And that’s because there are no limitations as to how much investment you can contribute as an employer or employee.

SEP IRA Tax Deduction

Yes, employers can enjoy the tax-deductible contributions made to a simplified employee pension (SEP) IRA. The amount, however, is restricted for annual deductions.

And all EE's, if eligible to be added to the retirement plan, can begin to receive tax-deferred contributions made by the employer from their gross income. Those contributions must be an equal percentage among the business owner and the employees.

Employers can contribute as high as 25% of a particular employee’s annual salary, given the total amount doesn’t go over $56,000. And self-employed individuals can benefit the contribution of at least 20% of their adjusted annual taxable income.

Freelancers, self-employed individuals, and small business owners can utilize the traditional types of SEP IRAs. It is important to remember that employees cannot contribute any share of the amount to a company’s SEP-IRA.

As of 2019, the amount of compensation used to calculate the 25% limit is capped at $280,000 for employees.. And SEP IRA can be helpful for self-employed individuals that want the flexibility to sort out cash flow irregularities.

Employers don’t necessarily have to contribute every single year. And the strategy to devise a contribution plan to compensate fairly should be based on the facts and services performed by employees during the tax year.

And contributions can be made even after the termination of employment or untimely departure of an employee.

What are the Disadvantages to a SEP IRA?

The SEP IRA works in favor of employers and employees, but it can create hurdles for both parties. Keeping that in mind, here are some of the disadvantages associated with a SEP-IRA plan:

Requires Instant Vesting

Companies desperately want to decrease the overall employee turnover and cost incurred to train new employees. Thus, employers prefer to hire workers that can work for a few years before final consideration to be vested in the firm’s contributions.

The amount of contribution in a SEP IRA is 100% vested by an employer. As a result, employees get to withdraw money immediately.

And loans are generally not permitted in a SEP-IRA. And below the minimum required amount is not even shown under employees’ net income without excessive contributions.

Eligibility Criteria for Employees

The eligibility requirement for an employer to set up a SEP IRA is that he or she should be at least 21 years old and should have minimum work experience of three out of the past five years. Also, the employee must have earned at least $600 from the employer in the past year.

The qualified plan of the simplified employee pension (SEP) IRA allows an employer to burden an employee with roughly 1000 hours of workload to get one year of service. Furthermore, the time limit as to what qualifies to be 'one-year of service’ is quite vague in a SEP IRA.

Also, the cost increases for the funding of the plan. And when expenses are higher than expected, businesses who mostly employ independent freelancers are affected.

Doesn’t Allow Borrowing

Employer or employee cannot borrow money against the SEP IRA plan. And the situation becomes even more disadvantageous for both parties who may be in dire need to get additional funds.

You can withdraw the money but at the cost of a severe penalty. Distributions from the SEP IRA are subject to severe penalties when made before the age of 59 1/2.

Contrary to other IRA accounts, SEP IRA also does not allow emergency withdrawals to pay tuition fees or have medical care.

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Non-Existing Catch-Up Feature

Individuals older than 50 are not allowed to make contributions in the SEP IRA. Meanwhile, other retirement plans such as 401(k) offers an integrated catch up provision that allows you to make $5,500 additional contributions for people older than 50.  

The total contribution to a SEP IRA is still higher than the other plans. And comparatively, Roth IRA has a limit of $5000, and SIMPLE IRAs allows just $2,500 in annual contributions for people over 50 years old.

Possible Discrimination

The employees who are eligible to make contributions to a SEP IRA may not make the final cut. And all because the employer might have misguided preconceived notions regarding certain employees.

Employees can still get excluded even if they fall under a union agreement that protects their retirement benefits. Moreover, the workers who are not permanent residents of the U.S can also face expulsion from the SEP IRA plan.

Who Can Benefit Most from SEP IRA?

Business owners who operate as LLC, S corporation, partnership, and as a sole proprietorship can largely benefit from the SEP IRA.

And the tricky part is how SEP IRA could be advantageous so long as the company doesn’t have any employees. Why? You would have to pay the same share of contribution to the employees as you would allocate to yourself.

The downfall is not making contributions for your employees, but how it can reduce tax savings altogether. SEP IRA could work as a savior for business owners who have to deal with large tax bills.

You can only set up and fund a SEP IRA account after the end of a tax year. Thus, a SEP IRA is more suitable for business owners who want to make deductibles at the very end of the past year.

The SEP seekers can go through the option to diverse the contributions for an investment. This includes inverse exchange-traded funds (ETFs) and share of stocks that profit from unpredictable markets.

The majority of the people would benefit from high tax-deductible contributions in 2019. And they will also be able to save approximately $6,000 annually through catch-up provision.

The underlying disadvantage of SEP IRA is that it doesn’t protect the profits from any investment for a taxable year. And that makes it somewhat discouraging for investors who can manage their affairs with bare minimum resources. Besides, investors need to analyze the market shift and trends to see if it’s vulnerable to investments such as bonds.

The SEP IRA is ideal for small business owners to manage company portfolio without tax penalties. The criteria to fund the plan could be made on your total return on investment and changing market conditions.

If you missed the deadline for qualified plan,  the tax law allows you to fund a SEP IRA for a brief period and then switch to a qualified plan.

Combining SEP IRA and Other Plans

You can fund additional amount of your income to a Roth IRA or traditional IRA along with SEP IRA. It might accumulate quite a bit of saving in a short period. The combination of funding for individuals over 50 years would mean that the total amount of contribution during a tax year would be between $59,500 - $61,500.


Small business owners can't overlook the simplicity of cost structure designed in SEP IRA. And even if it may seem viable to set up the SEP, always consult a tax specialist to make sure your business is compatible or not to handle certain business operations.

Whether you’re a small business owner or a large S corporation, you can benefit from expanded retirements savings accounts as opposed to doing nothing.

A company shouldn’t have the authority to decide which employees to benefit and not. The contribution should be made for all employees or not at all.

Christopher Ragain, CPA

Christopher Ragain, CPA is the founder of Halon Tax and one of the industries top authorities on micro-business taxation and tax planning.

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