How to Set Up a SEP IRA for a Sole Proprietor

A Simplified Employee Pension, or SEP IRA, is a retirement savings plan structured for self-employed individuals and small business owners. For a sole proprietor, this plan offers a straightforward method to save for retirement. Its appeal lies in simplified administration, substantial tax-deductible contributions, and minimal setup requirements.

This structure allows a sole proprietor to make significant contributions toward their own retirement, directly tied to their business’s profitability for the year. The flexibility to decide whether to contribute each year provides a level of control that is well-suited to the fluctuating income streams often experienced by the self-employed. It is an effective tool for turning business success into long-term financial security without the administrative burden of other retirement plans.

Eligibility and Plan Establishment

To establish a SEP IRA, an individual must have self-employment income from work as a sole proprietor, independent contractor, or freelancer. If you report income on a Schedule C of Form 1040, you are eligible. The existence of net profit from your business activities is the foundational requirement for making contributions, though a plan can be established even in a year with a net loss.

The plan is formally created by completing IRS Form 5305-SEP. This standardized document is the official written agreement and does not require submission to the IRS. The sole proprietor completes the form, signs it, and retains it for their personal records.

The deadline for formally establishing the plan is your business’s tax filing deadline for the year you wish to make your first contribution, including any extensions. For most sole proprietors, this means the plan must be adopted by April 15 of the following year, or October 15 if a valid tax filing extension is in place.

Calculating Your Maximum Contribution

The amount a sole proprietor can contribute to their own SEP IRA is governed by specific IRS limits. For 2024, the contribution is capped at the lesser of 25% of your compensation or $69,000, and for 2025, the dollar limit increases to $70,000. However, determining the correct “compensation” figure is not as simple as using the net profit from your business records.

The calculation begins with your net profit from self-employment, which is the figure found on your Schedule C. From this amount, you must subtract one-half of your self-employment taxes. The self-employment tax, calculated on Schedule SE, consists of Social Security and Medicare taxes for individuals who work for themselves.

The result of this subtraction is your “net adjusted self-employment income,” and this is the compensation figure used for the SEP IRA calculation. While the nominal contribution limit is 25%, the effective rate for a sole proprietor works out to be 20% of this net adjusted self-employment income. This is because the contribution itself is a deductible expense that reduces the income on which it is based.

To illustrate, consider a sole proprietor with a Schedule C net profit of $100,000. First, they would calculate their self-employment tax. Assuming the tax is $14,130, they would deduct half of that, or $7,065, from their net profit. This results in a net adjusted self-employment income of $92,935. The maximum SEP IRA contribution would then be 20% of this amount, which is $18,587.

The Account Opening and Funding Process

After establishing your plan and calculating your contribution, you must open the financial account. You will need to choose a financial institution, such as a brokerage firm, mutual fund company, or bank, that offers SEP IRA accounts. The process is similar to opening a traditional IRA; you will complete the institution’s application to open a SEP IRA.

After the account is open, you can fund it by transferring money from your business bank account. Common methods include writing a check from your business account made payable to the financial institution for credit to your SEP IRA, or initiating an electronic funds transfer (EFT). It is important to make the contribution from your business funds, as it is an employer contribution.

The deadline for making this contribution is your tax filing deadline, including extensions, for the tax year in question. Once the funds are in the SEP IRA, they must be invested to grow over time. Investment decisions are based on your personal risk tolerance and goals, and the account provider will have resources to help you select investments.

Ongoing Management and Tax Reporting

Ongoing responsibilities for a SEP IRA are minimal. You must report your contribution on your personal tax return to receive the tax deduction. The amount you contribute is deductible on Schedule 1 of your Form 1040, which is used for “Additional Income and Adjustments to Income,” and this deduction directly reduces your adjusted gross income (AGI).

A benefit of the Form 5305-SEP plan is the lack of annual IRS filing requirements. Unlike more complex qualified plans that may require an annual Form 5500 series return, a sole proprietor with no employees does not have this administrative task. This simplification is a reason many self-employed individuals choose this plan; your only recurring duty is to keep the original form in your records.

Contributions are flexible. You are not required to contribute every year and can vary the amount based on business performance, contributing more in profitable years and less or nothing in leaner years.

Withdrawals from a SEP IRA are treated similarly to those from a traditional IRA. The money you withdraw in retirement is taxed as ordinary income at your then-current tax rate. If you take a distribution before reaching age 59½, the amount is typically subject to a 10% early withdrawal penalty in addition to the ordinary income tax, and Required Minimum Distributions (RMDs) must begin once you reach age 73.