How Does a Simplified Employee Pension (SEP) IRA Work?



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The Internal Revenue Service allows business owners to set up traditional Individual Retirement Accounts, or IRAs, for their qualifying employees. Unlike standard IRAs, these accounts have the ability to receive employer contributions; SEP IRAs also have higher standard annual contribution limits than standard IRAs. Fundamentally, an SEP IRA can be considered a traditional IRA with the ability to receive employer contributions. One major benefit it offers employees is that employer contributions are vested immediately.


Who Participates in an SEP IRA Plan?


Per IRS rules as of 2017, to qualify for an employee SEP IRA, an individual must be at least 21 years old, have worked for the employer in at least three of the previous five years and have received a minimum of $600 in compensation from the employer during the current year. Individual employers are allowed to be less restrictive in their qualification requirements for their specific SEP IRA plans but may not be more restrictive than IRS rules.

Certain types of employees may be excluded by their employer from participating in an SEP IRA, even if they would otherwise be eligible per the plan rules. For example, workers who are covered in a union agreement that bargains for retirement benefits can be excluded. Workers who are nonresident aliens can also be excluded as long as they do not receive U.S. wages or other service compensation from the employer. Not all businesses can start SEP IRAs, which were primarily designed to encourage retirement benefits among businesses that would otherwise not set up employer-sponsored plans. Sole proprietors, partnerships and corporations can establish SEPs.


SEP IRA Functionality


An SEP IRA is an attractive option to many business owners because it does not come with many of the start-up and operating costs of most conventional employer-sponsored retirement plans. Many employers also set up an SEP plan to contribute to their own retirement at higher levels than a traditional IRA allows.

SEP IRA accounts are treated like traditional IRAs for tax purposes and allow the same investment options. The same transfer and rollover rules that apply to traditional IRAs also apply to SEP IRAs. When an employer makes contributions to SEP IRA accounts, it receives a tax deduction for the amount contributed. Additionally, the business is not "locked in" to an annual contribution; decisions about whether to contribute and how much can change each year.

The employer is not responsible for making investment decisions; rather, the IRA trustee determines eligible investments and the individual employee account owners make specific investment decisions. The trustee also deposits contributions, sends annual statements and files all required documents with the IRS. As of 2017, contributions cannot exceed the lesser of 25% of the employee's compensation for the year, or $54,000. This is significantly higher than the $5,500 limit imposed on standard IRAs.


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