SEP IRA and How It Works

In a sense, a SEP IRA functions as a hybrid of a traditional IRA and a 401(k). The money you invest in the account is tax-deductible, and employer contributions can be vested immediately.  

Here are some essential details you need to keep in mind while investing in SEP IRAs:

  • Rules on Withdrawal: Your funds can be withdrawn at any time, subject to the general limitations on traditional IRAs. That means; every withdrawal incurs regular income taxes. Moreover, any withdrawals made before age 59 1/2 incur a 10% additional tax. 
  • Contributions are Proportional: The same percentage must be contributed for every employee. So, if you put in 10% for your pay, you must also contribute the same amount for your employees' pay.

  • No Roth Version: SEP IRA has no option to fund your account with after-tax money. But if you wish to do so, you can convert your SEP into Roth using rollover or a transfer.
  • Option to Combine with Traditional or Roth IRA: If you qualify, you can open a SEP IRA along with other retirement accounts. This will allow you to have more options in saving for your retirement.

If you're already considering a SEP-IRA plan, keep scrolling because there is more information for you to peruse!

Who can Contribute to a SEP IRA

Any employer, from self-employed to a corporation, can set up a SEP-IRA plan for their employees. According to IRS standards, employees who qualify under the following criteria can participate:

  • At least 21 years old
  • Has worked under the employer for at least 3 years out of the last 5 years
  • Has earned at least $650 (compensation requirement for 2021-2022)  from the employer during the year

Note: Employees covered by a union agreement and those that are nonresident-aliens can not be included in SEP-IRAs.

How So I Set Up a SEP IRA

Setting up a SEP IRA is relatively simple. There are only several steps you need to complete:

  1. Choose a provider who will hold your SEP IRA.
  2. Formalize your agreement to open a SEP-IRA. You can do this by completing the IRS Form 5305-SEP or signing the IRS-approved prototype SEP provided by your chosen provider or financial institution. Another alternative is to complete an individually designed SEP plan.  
  3. Provide information about SEP to eligible employees. You can give them a copy of FORM 5305 or obtain similar information from your provider. 
  4. Work with your account provider to set up separate SEP-IRAs for each qualified employee.

How much Can I Contribute to SEP IRA

The contributions you make for each participating employee should be: 

  • Strictly based on the first $305,000 of compensation. 
  • Proportional to your employees’ compensation. 
  • Limited to the lesser of 25% of employee compensation or $61,000 (subject to annual cost-of-living adjustments for subsequent years). 

Note: Above information below is updated for the year 2022.

If you’re self-employed, your contribution is your net earnings less one-half of your tax less your contributions to your SEP-IRA plan. You can browse IRS’ Publication 560 for more details here

Note: You are not required to contribute every year. In years that you do contribute, it must be made to all eligible employees. Moreover, it must be made in cash; properties are not allowed. If you mistakenly made more contributions than the annual limits, here’s how you can correct this mistake.

Pros and Cons of SEP IRA

A SEP-IRA provides features that can benefit those who want to invest large amounts in their retirement savings. We’ve listed the pros and cons of a SEP-IRA to help you make an informed decision based on your specific needs. 

Pros of Investing in SEP-IRA

Ease of Setting Up

You can establish a SEP-IRA in just a few steps. See our guide above.

High Contribution Limit

You can contribute up to the lesser of 25% of compensation or $61,000. A few thousand higher than traditional and Roth IRAs, which is limited to $6,000 or $7,000 (if you're over 50 years old).


You are not required to contribute annually. You can do it at your own discretion as long as you contribute to all qualified employees.

Tax-deferred Savings

You do not have to pay taxes on the money you contribute today. This includes contributions made to employee accounts.

Tax-deductible Contributions

You can deduct the lesser of your contributions or 25% of your compensation from your gross income (subject to the compensation cap: e.g., $305,000 for 2022 and $290,000 for 2021). Also, if you're self-employed, the deduction is 25% of your net earnings.

Cons of Investing in SEP-IRA

No Catch-up Provisions Offered

Some retirement savings plans like SIMPLE and traditional IRAs allow investors aged 50 or older to make additional contributions.  You don’t have this option with SEP-IRAs.

Required Minimum Distributions

You must take mandatory withdrawals once you reach 72 years old.  Because any withdrawal on your account entails taxes, some investors feel they are being penalized, especially if they don’t need or want the money.

Early Withdrawal Penalty

Withdrawals made before age 59 ½ are subject to a 10% additional tax unless it satisfies one of the exceptions.

Contributions must be proportional

Proportional contributions must be made to each qualified employee if you contribute for yourself.

No Roth Option

You cannot choose to make contributions with after-tax money.  There is no option in SEP-IRA that will allow you to pay taxes now and take withdrawals tax-free in the future, unlike with Roth IRAs.


If you’re still new to investing in IRAs, it’s no surprise to be confused between SEP and SIMPLE IRAs. For your convenience, we’ve listed some of the main distinctions below:




Target Participants

Self-employed individuals to corporations

Small business with 100 or fewer employees


Employers only

Employer and employees

Account Holder Qualifications

Must be at least 21 years old, employed for at least 3 years out of 5, and earned a compensation income of at least $650.

The employee must have earned at least $5,000 within two years, whether consecutive or not, and are expected to make as much during the calendar year.

Contribution Limits

25% of employee’s compensation or $61,000, whichever is lower.

$14,000 for those under 50 and a maximum catch-up contribution of $3,000 for those beyond 50 years.

Tax Deductible



Tax Deferred



Can I Withdraw Money From My SEP IRA?

Yes, you can withdraw money from your SEP IRA at any time, but there are some restrictions. Your withdrawal may not be deductible in your taxable income and may incur a 10% additional tax if you have not reached the age of 59 1/2. There are, however, some exceptions to this rule. Here are some: 

Permanent or total disability

If you can no longer work due to a permanent disability, the IRS will allow you to withdraw money without incurring the 10% penalty. You can use the funds for any purpose as long as you provide proof of your disability to your plan administrator.

Medical expenses

If you’re not covered by health insurance and have out-of-pocket medical expenses, you can get penalty-free distribution to pay for these. Note that it must be paid the same calendar year you requested the withdrawal. Moreover, your unreimbursed medical expenses must exceed your 2022 adjusted gross income by about 10%.

To Illustrate: If your income is $200,000 and the unpaid expenses totals $25,000, then the penalty-free distribution will only cover $5,000 (e.g. $25,000 less the 10% of $200,000). 

Qualified higher education expenses

This generally covers tuition, books, supplies, equipment, and other fees required for enrollment. For students enrolled at least half-time, room and board are also included.

First-time home buyer

You can withdraw a maximum of $10,000 without penalty as long as the money is used to buy, build, or rebuild a house. The condition is you must be a “first-time” homebuyer and haven’t owned a home for the past two years.

If you want to learn more about the withdrawal rules and their exceptions, check out the 


The advantage of saving pre-tax money for retirement and offering benefit plans for your employees can be appealing. SEP-IRAs allow small business owners and self-employed individuals like yourself to establish a retirement plan quickly. 

Still, there are a few drawbacks to investing in one. Its inability to allow employees to make contributions and the requirement for business owners to contribute the proportional percentage for all qualified employees might be worth pondering. 

If you have anything you’re still not sure of, contact us to get more information about setting up a SEP IRA or investing in one.

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