"I got a buddy that has a guy that threw some money in an account at the end of last year." Does this sound like your in-depth knowledge of what a small business retirement account is? We're here to give you the rundown on a retirement account option for small businesses that can also offer possible tax savings. I will explain what a SEP IRA is, then share some positive use cases and lastly some snags people may run into.
What is a SEP?
A SEP IRA stands for Simplified Employee Pension (SEP) and Individual Retirement Account (IRA). This is prevalent for small business owners because it is an account tied directly to the business. Unlike a traditional IRA that is tied to the individual, the SEP is tied to the business itself. Contributions are 100% employer funded as employees cannot defer any of their salary into the account. This account was designed as a tax-advantaged retirement plan specifically for self-employed individuals and small businesses. As its name suggests it is simpler than a full blown 401k, but can have some limitations as well.
The benefits of using a SEP
- The most sought after benefit of the SEP is possibly the tax-advantaged status. This means any contribution made is tax deductible because the employer is funding the account. This deduction comes as an "above the line" deduction (sole proprietors) or as a business expense (corporation). Along with the deduction, the funds in the account can be invested and those investments may grow tax-deferred (no recurring tax) until the funds are distributed.
- The flexibility and higher savings cap is what sets the SEP apart from other retirement accounts. Contributions are optional and can be made up to your tax filing deadline. This flexibility allows businesses to work with professionals to calculate tax impact after the calendar year ends and determine contribution amounts depending on cash flow. This advantage can offer significantly higher potential contribution limits compared to an individual IRA. The contribution limits set by the IRS are:
- Owners can contribute up to 25% of eligible compensation or
- Up to $72,000 for 2026, whichever is less.
- The last benefit to mention is that SEP IRAs involve significantly less administrative complexity and overhead than comparative 401(k) plans. This allows accounts to be opened and funded fairly quickly.
The unforeseen challenges of using a SEP
- The most commonly misunderstood rule of a SEP is employee funding. If you have employees and want to make a contribution for yourself, you are required to contribute the exact same percentage for every eligible employee. You cannot exclude or give a lower contribution rate to employees. This is why we recommend SEP's for self employed individuals or small firms such as a small insurance agency with a couple of employees. As previously mentioned, employees are unable to contribute at their own discretion, meaning they rely entirely on the owner's decisions, which limits the flexibility of this benefit for them.
- Another obstacle that is not as frequently discussed is the constrained capacity for growth. SEPs do not easily allow for growth of an organization if new hiring will be involved. It becomes too costly and doesn't offer the benefits that employers want to offer such as loan provisions, catch up contributions and employee participation. Additionally, entity structure can impact this by a business owner drawing a paycheck (likely as an S-Corp) may be limited on their total contribution amount. This is why we sit with our clients to understand their goals to recommend the right retirement account for them and their business.
Should I Use a SEP IRA?
Hopefully, this was informative to help decide if a SEP IRA is right for you. I highly recommend sitting with the professionals in your life to discuss this decision. If you need a trusted guide through this process, schedule a no-hassle appointment through our website.
"The more you learn, the more you earn." (Warren Buffett)
This material is for educational purposes only and does not constitute tax, legal, or investment advice. Tax laws are complex and subject to change. Please consult with a qualified tax professional or legal advisor regarding your specific situation before making financial decisions.