Can a Partnership Open a SEP IRA for K-1 Income?

A Simplified Employee Pension (SEP) IRA is a retirement savings plan that allows employers, including partnerships, to contribute to individual retirement accounts for themselves and their employees. For partners who receive income through a Schedule K-1 rather than a traditional salary, determining eligibility and contribution limits can be more complex than for standard W-2 employees. Understanding how SEP IRAs work in the context of partnership income ensures compliance with IRS rules while maximizing retirement savings.

Partner Participation Criteria

A partnership can establish a SEP IRA, but all eligible partners and employees must be included. Eligibility typically requires participants to be at least 21 years old and to have worked for the partnership in at least three of the last five years. These criteria must be applied uniformly.

Since SEP IRAs are employer-funded, contributions come from the partnership rather than individual partners. The partnership must apply the same contribution percentage to all eligible participants. For example, if the partnership contributes 15% of compensation, that percentage must be applied consistently across partners and employees. The IRS limits contributions to the lesser of 25% of compensation or $69,000 per participant for 2024.

While SEP IRAs avoid the complex nondiscrimination testing required for 401(k) plans, they must still ensure contributions do not disproportionately favor highly compensated partners over lower-earning employees. If the partnership has non-partner staff, contributions must be made for them at the same percentage as for partners. Failing to meet these requirements can result in plan disqualification and tax penalties.

K-1 and Calculating Compensation

Partners do not receive W-2 wages, so their SEP IRA contributions are based on net earnings from self-employment, as reported on Schedule K-1 (Form 1065). However, the amount eligible for SEP IRA contributions must be adjusted before applying the contribution percentage.

Net earnings from self-employment are calculated by subtracting allowable deductions, including the self-employment tax deduction, from the partnership’s ordinary business income. Since partners pay both the employer and employee portions of self-employment tax, the IRS allows them to exclude half of this tax liability before determining their SEP IRA contribution base.

For 2024, the self-employment tax rate is 15.3% on net earnings up to $168,600, with the Medicare portion (2.9%) continuing beyond this threshold. Because SEP IRA contributions are based on net income after deducting the contribution itself, a circular calculation is required. The effective maximum contribution rate for self-employed individuals is approximately 20% of adjusted net earnings. For example, if a partner’s net earnings after the self-employment tax adjustment are $100,000, the maximum contribution would be $20,000 (100,000 × 20%).

Selecting a Custodian

Choosing a financial institution to hold a SEP IRA is important, as the custodian manages contributions, ensures regulatory compliance, and provides reporting documents. Banks, brokerage firms, and mutual fund companies offer SEP IRA accounts with varying investment options, fee structures, and administrative support. Some custodians focus on low-cost index funds, while others provide access to individual stocks, bonds, and alternative investments.

Administrative efficiency is another factor. Some custodians offer online platforms for managing contributions and generating required tax forms, while others require more manual recordkeeping. Since SEP IRA contributions must be reported on IRS Form 5498, selecting a provider with a track record of accurate and timely reporting reduces compliance risks. Some firms charge maintenance fees or trading commissions that can erode investment returns, making cost comparisons worthwhile.

Setting Up the Plan

Establishing a SEP IRA for a partnership begins with adopting a formal written agreement outlining the plan’s terms. The IRS provides Form 5305-SEP, a pre-approved document that simplifies this process, though partnerships can also use customized plans if they meet regulatory requirements. The agreement must specify eligibility rules, the contribution formula, and how the plan will be administered. While Form 5305-SEP does not require IRS approval, maintaining a signed copy in the partnership’s records is necessary for compliance.

Once the plan is adopted, the partnership must notify all eligible participants. This includes providing a written notice explaining how contributions are determined, when they will be deposited, and available investment options. Since SEP IRAs do not allow employee contributions, participants should understand that only employer-funded amounts will be deposited into their accounts.

Contribution Allocation

The partnership must apply a uniform percentage of each participant’s eligible compensation to comply with IRS rules. The percentage can vary from year to year, allowing flexibility based on financial performance. However, once a percentage is set for a given year, it must be applied consistently across all participants.

For partners, contributions are based on net earnings from self-employment, adjusted for deductions such as the self-employment tax. Employees receive contributions based on their W-2 wages. If the partnership elects to contribute 10% of compensation, a partner with $120,000 in adjusted net earnings would receive a $12,000 contribution, while an employee earning $50,000 in salary would receive $5,000. Contributions are discretionary, meaning the partnership is not required to contribute every year, but if it does, all eligible individuals must receive the same percentage.

Tax Reporting Obligations

SEP IRA contributions are tax-deductible for the partnership as a business expense, reducing taxable income. These deductions are reported on Form 1065, with each partner’s share reflected on their individual Schedule K-1. Unlike traditional retirement plans, SEP IRA contributions are not subject to payroll taxes, making them a tax-efficient way to save for retirement.

Each participant must report SEP IRA contributions on their personal tax return, but they do not count toward the annual IRA contribution limit for traditional or Roth IRAs. The custodian of the SEP IRA is responsible for filing Form 5498 with the IRS, detailing the total contributions made for each account holder. Failure to properly report contributions can result in penalties or disallowed deductions, so maintaining accurate records is important.

Withdrawal Provisions

While SEP IRAs offer tax-deferred growth, withdrawals follow standard IRA distribution rules. Participants can begin penalty-free distributions at age 59½, with withdrawals taxed as ordinary income. Early withdrawals before this age generally incur a 10% penalty unless an exception applies, such as qualified medical expenses or first-time home purchases.

Once a participant reaches age 73, required minimum distributions (RMDs) must begin. The amount is calculated based on the IRS Uniform Lifetime Table, and failure to withdraw the required amount results in a penalty of 25% of the shortfall. Since SEP IRAs function similarly to traditional IRAs in terms of distributions, participants should plan withdrawals carefully to minimize tax liabilities.