SEP-IRA

A Simplified Employee Pension IRA — a retirement account designed for self-employed individuals and small business owners that allows much higher contribution limits than a standard IRA, funded entirely by employer (or self-employed owner) contributions.

A SEP-IRA (Simplified Employee Pension Individual Retirement Account) is a type of retirement account specifically designed for self-employed individuals, freelancers, independent contractors, and small business owners. It allows significantly higher annual contribution limits than a traditional or Roth IRA — in 2024, up to 25% of net self-employment income or $69,000, whichever is less — making it one of the most powerful retirement savings vehicles available to people who work for themselves. SEP-IRAs are funded entirely by employer contributions (for self-employed individuals, this means contributions from their business income), not employee salary deferrals, and all contributions are immediately 100% vested.

The SEP-IRA's primary appeal is its simplicity and its high contribution ceiling. Setting up a SEP-IRA requires only completing IRS Form 5305-SEP (a single page) and opening an account at any brokerage that offers them — no IRS approval, no annual filing requirements (unlike a Solo 401(k) above $250,000 in assets), and no complex administration. For freelancers and independent contractors who earn substantial self-employment income and want a straightforward way to shelter a large portion of it from current taxes, the SEP-IRA is often the first recommendation. The contribution is calculated as approximately 20% of net self-employment profit (after the self-employment tax deduction) — not the full 25% — due to the way self-employment income is calculated.

SEP-IRAs have meaningful restrictions compared to Solo 401(k)s: they do not allow employee salary deferrals (only employer contributions), they do not support Roth contributions, and they don't allow loans. For self-employed individuals who want to make Roth-style contributions, maximize retirement savings beyond what a SEP-IRA allows, or access funds via a loan, a Solo 401(k) (also called an Individual 401(k)) is often a better option — it supports both employee deferrals and employer contributions, allows a Roth component, and can reach higher total contribution limits for lower-income earners. However, Solo 401(k)s require more administration and an IRS-issued EIN.

For small business owners who employ other people, the SEP-IRA has an important requirement: if you establish a SEP-IRA and contribute for yourself, you must also contribute the same percentage of compensation to all eligible employees (generally, employees 21 or older who have worked for you in 3 of the last 5 years and earned at least $750 in the current year). This makes SEP-IRAs most practical for solo operators — a business owner with several employees who contributes 25% of their own compensation must also contribute 25% of each eligible employee's compensation, which can be expensive. For this reason, businesses with employees often prefer SIMPLE IRAs or 401(k) plans.

SEP-IRA Contribution Calculation for Self-Employed

Self-employed individuals cannot simply take 25% of their gross self-employment income. The calculation involves several steps: (1) Start with net self-employment income (revenue minus business expenses). (2) Subtract the deductible portion of self-employment tax (50% of your SE tax). (3) The result is your 'net earnings from self-employment' for SEP purposes. (4) Multiply by approximately 20% (which equals the plan's 25% rate applied to compensation, since self-employment compensation is calculated as net earnings divided by 1.25). For example, a freelancer with $150,000 in net self-employment income after expenses would subtract ~$10,597 (half of SE tax), leaving roughly $139,403 — 20% of that is a SEP contribution of about $27,881. The IRS provides a worksheet in Publication 560 to calculate this precisely.

SEP-IRA vs. Solo 401(k): Which Is Better?

  • Contribution limits: SEP-IRA is capped at 25% of compensation/$69,000. Solo 401(k) allows employee deferrals ($23,000 in 2024 + $7,500 catch-up if 50+) PLUS employer contributions up to 25% of compensation — total can reach $69,000 (or $76,500 with catch-up), but at lower income levels the Solo 401(k) allows higher contributions.
  • Roth option: SEP-IRA is pre-tax only. Solo 401(k) can have a Roth component for the employee deferral portion.
  • Administration: SEP-IRA is extremely simple — no annual filing until assets exceed $250,000. Solo 401(k) requires IRS Form 5500-EZ once assets exceed $250,000.
  • Employees: SEP-IRA requires proportional contributions for all eligible employees. Solo 401(k) is only for owner-employees with no other full-time employees (spouses can participate).
  • Loans: SEP-IRA doesn't allow loans. Solo 401(k) may allow loans up to $50,000 or 50% of vested balance.
  • Best for: solo operators who want simplicity → SEP-IRA. Solo operators who want to maximize contributions or Roth access → Solo 401(k).

Tax Treatment and Deadlines

  • Contributions are tax-deductible as a business expense — they reduce your adjusted gross income, lowering both income tax and self-employment tax.
  • Contribution deadline: SEP-IRA contributions can be made up to the tax filing deadline including extensions — for sole proprietors filing Schedule C, this is October 15 of the following year. This is later than many other retirement accounts and makes SEP-IRAs useful for last-minute tax planning.
  • Withdrawals: taxed as ordinary income, same rules as traditional IRA — qualified withdrawals after age 59½, 10% penalty on early withdrawals, RMDs beginning at age 73.
  • No Roth option: all SEP-IRA contributions are pre-tax; there is no Roth SEP-IRA variant.

Example

A freelance software consultant earns $180,000 in net profit in a given year. After subtracting the deductible portion of self-employment tax (~$12,716), her net self-employment income for SEP purposes is $167,284. She can contribute approximately 20% of this — $33,457 — to her SEP-IRA by October 15 of the following year. This contribution reduces her taxable income by $33,457, saving her roughly $11,071 in federal income tax at a 33% effective rate, plus reducing her state income tax further. The contribution also reduces her AGI, potentially qualifying her for other income-based deductions. She opens a SEP-IRA at a brokerage in January and invests the full contribution in a diversified index fund portfolio.