How Does a Simplified Employee Pension (SEP) IRA Work?

A Simplified Employee Pension (SEP) IRA is a retirement plan established by an employer or a self-employed individual. Its design provides a direct method for making retirement contributions for business owners and their employees. The structure is particularly well-suited for small businesses and self-employed individuals due to its straightforward administration and flexible contribution requirements. This plan allows employers to set aside funds in dedicated individual retirement accounts for their eligible workers, fostering retirement savings without the complexities of more structured pension plans.

Establishing a SEP IRA Plan

Any business entity, from a sole proprietorship to a large corporation, is eligible to establish a SEP IRA. The creation of the plan is formalized through a written agreement. The most common way to satisfy this requirement is by completing and signing IRS Form 5305-SEP, the “Simplified Employee Pension – Individual Retirement Accounts Contribution Agreement.” This form serves as a model plan document that simplifies the setup process.

Before finalizing the plan document, the employer must make several decisions that dictate how the plan will operate. This includes formally naming the plan and defining the specific requirements for employee participation. These choices are documented within the Form 5305-SEP agreement.

Once the employer completes and signs Form 5305-SEP, the plan is officially established. This document is not filed with the IRS but is instead retained by the employer as the official governing instrument of the plan. Using Form 5305-SEP is only permissible if the employer does not maintain any other type of qualified retirement plan, with the exception of another SEP. After establishing the plan, the employer must provide a copy of the completed Form 5305-SEP to all eligible employees.

Funding the SEP IRA

A defining feature of the SEP IRA is that only the employer is permitted to make contributions; employees cannot contribute their own funds to these accounts. Contributions are made directly by the employer into a separate SEP IRA that is set up for each eligible employee.

The amount an employer can contribute is subject to annual limits set by the IRS. For any given year, the contribution for each employee cannot exceed the lesser of 25% of their compensation or a specific dollar amount. The dollar limit is $70,000 for 2025. For example, if an employee earns $80,000, the maximum contribution would be $20,000 (25% of $80,000), as this is less than the $70,000 annual cap.

One of the main attractions of a SEP IRA for business owners is the contribution flexibility. Employers are not obligated to make contributions every year, allowing a business to adjust funding based on financial performance. When an employer does choose to contribute, the deadline for making those contributions for a specific tax year is the due date of the employer’s federal income tax return for that year, including any extensions.

Employee Participation and Account Management

An employee must be included if they have reached age 21, worked for the employer in at least three of the last five years, and earned at least $750 in compensation during the year. If an employer decides to make a contribution for a given year, they must do so for every employee who meets these eligibility criteria. The contribution rate must be the same percentage of compensation for every eligible employee.

To receive these employer contributions, each eligible employee must establish their own traditional IRA, which is designated as their SEP IRA. The employer then deposits the contribution funds directly into these individual accounts. A benefit for employees is that they are always 100% immediately vested in all employer contributions. This means the money belongs to the employee from the moment it is deposited.

Once the funds are in the employee’s SEP IRA, the employee has complete control over the investment decisions for that account. They can choose how to allocate the funds among various investment options offered by the financial institution holding the IRA, such as stocks, bonds, and mutual funds. The funds within a SEP IRA are portable. An employee can roll over the assets from their SEP IRA into other retirement accounts, such as another traditional IRA or an eligible employer-sponsored plan like a 401(k).