What Is a SEP IRA? – A Practical Retirement Savings Strategy for Small Business Owners

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If you operate a small business or work as a self-employed professional, these questions often come up:

  • “Setting up a company 401(k) feels too complex and expensive.”
  • “I still want to prepare properly for retirement.”
  • “Is there a retirement plan that works when I have only a few employees — or none at all?”

In situations like these, one of the most practical retirement plans to consider is a SEP IRA.

What Is a SEP IRA?

A SEP IRA (Simplified Employee Pension Individual Retirement Account) is a retirement plan designed specifically for small business owners and self-employed individuals. It combines simple administration with much higher contribution limits than a Traditional IRA.

In plain terms:

A SEP IRA is an IRA funded by the employer, with simple rules and generous contribution limits.

Key Features at a Glance

  • Like a Traditional IRA, each account is owned individually by the participant.
  • Only the employer can make contributions; employees and owners cannot contribute personally.
  • Employer contributions are treated as deductible retirement plan contributions, reducing taxable business income.
  • Funds in a SEP IRA grow tax-deferred, meaning no annual taxes while invested; income tax applies only when money is withdrawn in retirement.

Real-World Example ①

Self-Employed Individual with No Employees

Mr. Kim is a freelance IT consultant earning approximately $180,000 in annual net profit. He has no employees.

His retirement plan options:

  • Traditional IRA: $7,000 annual limit (2025, under age 50) → too small
  • Solo 401(k): Viable but more administrative work
  • SEP IRA: ✔ Chosen

In 2025, Mr. Kim contributed $25,000 to a SEP IRA, calculated within the allowable limit based on his adjusted net earnings.

This $25,000 is reported as a retirement plan contribution deduction, reducing his taxable business income.
Both the contribution and any future investment earnings grow tax-deferred inside the SEP IRA, with taxes paid only when funds are withdrawn in retirement.

For self-employed individuals without employees, a SEP IRA is often the simplest way to make large retirement contributions.

Who Can Establish a SEP IRA?

A SEP IRA may be established by:

  • Sole proprietors (Schedule C filers)
  • Partnerships
  • S corporations and C corporations
  • Small businesses with employees

If you have employees, employee eligibility rules must be followed carefully.

Employee Eligibility Requirements (General Rules)

An employee is generally eligible for SEP IRA contributions if they:

  • Are at least 21 years old
  • Earned at least $750 during the year
  • Worked for the employer in 3 of the last 5 years

Employers may relax these requirements (for example, reduce the service requirement), but may not make them more restrictive than allowed by law.

Real-World Example ②

Small Business with Employees

Mr. Chen owns a small bakery and employs three workers.

  • Mr. Chen’s compensation: $100,000
  • Employee A: $40,000
  • Employee B: $35,000
  • Employee C: $30,000

Mr. Chen decides to contribute 5% of compensation to a SEP IRA.

Resulting contributions:

  • Mr. Chen: $5,000
  • Employee A: $2,000
  • Employee B: $1,750
  • Employee C: $1,500

Important Rule

You cannot contribute a higher percentage for yourself and a lower percentage for employees.
The same percentage must apply to all eligible participants.

SEP IRA Contribution Limits (2025)

For 2025, SEP IRA contributions are limited to the lesser of:

  • 25% of compensation, or
  • $70,000

Example

  • Employee earning $200,000 → maximum contribution: $50,000
  • Employee earning $350,000 → compensation is capped for calculations → maximum contribution: $70,000

Important SEP IRA Rules

Equal Contribution Rule

All eligible employees must receive the same contribution percentage.

Contribution Deadline

Contributions are due by the business tax filing deadline, including extensions.

Immediate Vesting

All contributions are 100% immediately vested. Employees keep the money even if they leave the company.

Withdrawal Rules

  • After age 59½: No early-withdrawal penalty; ordinary income tax applies
  • Before age 59½: Income tax plus a 10% penalty may apply
  • Required Minimum Distributions (RMDs) begin at age 73

SEP IRA Investment Options

SEP IRAs offer the same flexibility as Traditional IRAs, including:

  • Stocks
  • Bonds
  • Mutual funds
  • ETFs

Investment decisions are made by the account owner, not the employer.

Who Is a SEP IRA Best For?

Especially effective when:

  • You have few or no employees
  • You are self-employed or a one-person business
  • You want a simple plan with high contribution limits
  • Your income fluctuates and you want flexibility

May be costly when:

  • You have many employees
  • Total payroll is high due to the equal contribution requirement

Final Thoughts

A SEP IRA is not a one-size-fits-all solution, but:

When the situation is right, it can be one of the simplest and most powerful retirement savings tools available.

For many small business owners, it is a plan worth reviewing before committing to a full 401(k) setup.

2026 SEP IRA Contribution Limits (Quick Reference)

  • Up to 25% of compensation, or
  • A maximum of $72,000,
  • Whichever is less

The Most Common Mistake: Understanding the “25% Rule”

A frequent misunderstanding:

“My net profit is $200,000, so I can contribute $50,000.”

This is incorrect for self-employed individuals.

SEP IRA contributions for the self-employed are based on adjusted net earnings, not raw net profit.

IRS Calculation Overview

  1. Start with net profit
  2. Subtract ½ of self-employment tax
  3. Subtract the SEP contribution itself
  4. Apply the 25% limit

In practice, this results in a lower effective percentage than many expect.

Example (2026)

  • Net profit: $200,000
  • Self-employment tax (approx.): $30,600
  • Half of SE tax: $15,300

Adjusted base:
$200,000 – $15,300 = $184,700

Maximum SEP IRA contribution: approximately $37,000, not $50,000.

Key Takeaway

For self-employed individuals, SEP IRA contributions must always be calculated using adjusted net earnings — not net profit alone.

Note: This article is intended for informational purposes only and does not constitute tax advice. For personalized guidance, please consult a tax professional.