How Does A SEP IRA Work?

A Simplified Employee Pension Individual Retirement Account, or SEP IRA, is a retirement plan for all employees, including the self-employed and business owners. It can be a great decision for retirement savings because it allows large contributions that make preparing for your older years more reassuring. The idea is simple: work, earn, save, and enjoy a comfortable retirement. Moreover, employer contributions are not reported on employee W-2 forms since deposits of SEP IRA are not subjected to taxation.

Your boss finances SEP IRAs, and while, as an employee, you don't deposit a dime directly, you certainly benefit from what is deposited for you. Most of the major appeal goes both ways; while the employee enjoys a flexible plan, the employer enjoys a plan so simple that even small businesses or any business, regardless of size or the number of employees, is able to put in place.

Each year, the U.S. Internal Revenue Service limits how much can be deposited into a SEP IRA. The latest is the lessor of $70,000 or 25% of an employee's compensation. In other words, a contribution up to 25% of the employee's salary may be provided but it cannot exceed the total of $70,000 for the year.

As in other retirement funding vessels, the U.S. sets forth rules establishing the SEP IRA. To qualify, an employee must be above the age of 21 years and must have worked under the same employer for three out of the five years. In addition, the employee must have earned at least $750 during these years. The IRS allows the employers a chance to reduce requirements such as the age or years of work to make qualification easier for an SEP IRA. However, they again cannot make these rules tougher — for example, by increasing the required years to 10 or the earnings to $1,000. Plus, they have to invest the same percentage of money into every qualified employee's SEP-IRA according to the requirement of the IRS.

Employees do not directly contribute to their SEP IRA; rather, according to the IRS, employees can put money into a traditional or Roth IRA with annual limits of $7,000 for those under 50 and $8,000 for those 50 or over. The neat thing about SEP IRAs is that any money your employer adds belongs to you right away. That means you can manage and invest that money immediately, a perk not always seen in other plans, like the Simple IRA, which makes you wait two years before you fully own your employer's contributions.

When adding to a SEP IRA, employers should stick to the first $375,000 of an employee's gross pay when figuring out how much to contribute. This is the limitation set for 2025, which simply means that any earnings more than $375,000 are excluded when calculating SEP IRA contributions. Other charges that should concern you in 2025 are the new method of claiming spousal benefits, setting an appointment to visit your local Social Security office, and increased minimum wage in some U.S. states.

The contribution for a SEP IRA by self-employed persons is calculated with a number of steps. You have to take away from your gross income business expenses and half of your self-employment tax, to arrive at your net earnings, then you take 25% of that and put it into your SEP IRA savings account, and though it's okay to deposit up to 25% of your earnings into your SEP IRA, the actual amount is a bit less because these contributions count as a business expense. Fortunately, the IRS has worksheets and tools that are pretty easy to use and will help determine just how much you can contribute to stay within the rules without any mix-ups.

There are some rules governing early dipping into your SEP IRA savings. If you withdraw money from your IRA before age 59 1/2, you will incur a 10% penalty. If you remove $10,000, the penalty will be $1,000 and you will additionally pay taxes on the amount taken out, because SEP IRA treats any money you withdraw as a distribution income. Should you be less than 59 1/2 years old, you could be subject to an extra 10% penalty.

The SEP IRA does not permit loans, yet, there is an exception, which entails you repay the money, along with interest accrued, within a recognized 60 days. A loan is not seen as a distribution, hence neither income tax nor penalty analysis is done on the borrowed amount. Should you fail to return the loan, the remaining balance is handled as a distribution and you would be liable for income tax and the 10 percent penalty on that amount.

The SEP IRA guidelines also let you buy a first house or if you are totally or permanently incapacitated, it allows you to enjoy penalty-free withdrawals for eligible higher education costs. With these limitations, it would be a good idea to hold an emergency savings account against the onerous penalties and taxes. On the other hand, seek advice from a tax professional on the long-term tax implications, especially if you are a high earner.