Can a W2 Employee Contribute to a SEP IRA?
Understand how your self-employment income, separate from your W2 wages, is the key to funding a SEP IRA and enhancing your retirement strategy.
A Simplified Employee Pension, or SEP IRA, is a retirement plan for self-employed individuals and small business owners. It allows for higher contribution limits compared to traditional IRAs, making it an attractive option. A common question is whether individuals who earn W-2 wages as an employee but also have a side business can contribute to a SEP IRA.
An individual cannot make contributions to a SEP IRA based on wages they earn from an employer. However, if that same W-2 employee generates net earnings from a separate self-employment venture, they can establish and contribute to a SEP IRA based on that business income.
Eligibility Based on Self-Employment Income
A W-2 employee’s ability to fund a SEP IRA depends entirely on having qualifying self-employment income from a separate business activity. This includes earnings from freelance work, independent contracting, or a side business operated as a sole proprietor. This income is reported to the IRS on Schedule C, “Profit or Loss from Business,” which is filed with the annual Form 1040 tax return.
For example, a graphic designer who works full-time for a marketing agency cannot use their W-2 salary to fund a SEP IRA. If that designer also takes on freelance projects and receives direct payments from clients, that freelance income makes them eligible. The plan must be established under the name of their freelance business.
This structure means the individual acts as their own employer for the SEP IRA. Contributions made to the plan are considered employer contributions, even though the person is both the employer and employee for their side business. This differs from a 401(k), where employees can make their own salary deferrals.
Calculating Your Contribution Limit
The maximum you can contribute to a SEP IRA is based on your self-employment income. The contribution is limited to 25% of your net adjusted self-employment income, up to the annual IRS limit of $70,000 for 2025. This calculation results in an effective contribution rate of 20% of your net business profit after a specific deduction.
The first step is to calculate your net profit from self-employment, which is your gross income minus business expenses from Schedule C. Before determining your SEP IRA contribution, you must deduct one-half of your self-employment taxes from your net profit. This adjusted figure is your compensation base for the calculation.
Consider a freelance consultant with $80,000 in net profit on Schedule C. After calculating and subtracting one-half of their self-employment tax, their compensation base for the SEP IRA might be approximately $74,340. The maximum contribution would be 25% of that amount, or around $18,585. This contribution is then deducted on Schedule 1 of Form 1040, reducing the individual’s adjusted gross income.
How to Establish and Fund the Plan
To set up a SEP IRA, you must first choose a custodian, such as a brokerage firm or bank, that offers these accounts. The financial institution will provide all the necessary paperwork to open the account and establish the plan. While the IRS provides a model plan document, Form 5305-SEP, most institutions use their own IRS-approved documents, which you sign and keep for your records.
A SEP IRA can be established for a tax year up until the due date of the business’s tax return, including extensions. For most sole proprietors, this means the plan can be set up and funded by April 15 of the following year. An extension to file your taxes also extends the deadline to establish and fund the SEP IRA.
Once the account is open, the business makes the contribution to the individual’s SEP IRA. The contribution is made by the business, as the “employer,” using business funds. It is important not to mix personal and business funds when making the contribution.
Coordinating with Workplace Retirement Plans
Contributing to a SEP IRA does not affect your ability to save in a primary workplace retirement plan, like a 401(k) or 403(b). The contribution limits for these two plan types are separate, provided the SEP IRA is funded by a business unrelated to the W-2 employer. An individual can contribute the maximum to their 401(k) through salary deferrals and also make a separate employer contribution to their SEP IRA.
The annual limit on employee salary deferrals to a 401(k) is separate from the SEP IRA contribution limit. For 2025, the employee deferral limit is $23,500, with an additional catch-up contribution for those age 50 and over. Participation in a workplace 401(k) does not reduce the amount you can contribute to your SEP IRA as the employer of your side business.
The tax treatment for these contributions also differs. Traditional 401(k) contributions are pre-tax and reduce the taxable income on your Form W-2. In contrast, a SEP IRA contribution is an “above-the-line” deduction on Schedule 1 of your Form 1040. This directly reduces your adjusted gross income (AGI), which can help you qualify for other tax deductions or credits.