Is a SEP IRA a Defined Contribution Plan?
Explore how a SEP IRA's structure, from its defined funding to its employee-managed risk, places it within the defined contribution plan category.
Yes, a Simplified Employee Pension (SEP) IRA is a type of defined contribution plan. This classification means that while contributions are specified, the final retirement benefit for the employee is not guaranteed. For small business owners and self-employed individuals, understanding this structure is helpful when selecting a retirement savings vehicle.
Understanding Defined Contribution Plans
A defined contribution plan is a retirement plan where the amount of money contributed is specified, but the ultimate payout is variable. These plans use individual accounts for each employee, and the account’s value at retirement depends on total contributions plus any investment gains or losses.
The employee bears the investment risk, and the employer’s responsibility ends once they have made their specified contribution. There is no promise of a specific monthly income in retirement. Examples of defined contribution plans include 401(k)s, profit-sharing plans, and SEP IRAs.
These plans offer cost predictability for employers, as contribution amounts can be set as a percentage of profit or payroll. For employees, these plans provide ownership and control over their retirement funds, often allowing them to choose from a range of investment options.
How a SEP IRA Functions as a Defined Contribution Plan
With a SEP IRA, an employer makes contributions directly into a traditional IRA set up for each eligible employee. These employer contributions are flexible; a business can decide each year whether to contribute and how much, from 0% up to 25% of an employee’s compensation. Employees can also make their own contributions, subject to separate annual limits for traditional IRAs.
The annual employer contribution is capped by the IRS at $70,000 for 2025. Once the employer deposits these funds, their obligation for that year is fulfilled. The employee then takes full control of the account, making all investment decisions from the options provided by the financial institution.
This structure places the investment risk on the employee. The final retirement benefit is not a predetermined monthly payment but is the total value of the account upon withdrawal. This value is the sum of all contributions plus the cumulative investment earnings or losses. This direct link between contributions and a variable final benefit is what categorizes the SEP IRA as a defined contribution plan.
Key Distinctions from Defined Benefit Plans
In contrast, a defined benefit plan, often called a traditional pension, promises a specific monthly income to an employee upon retirement. This benefit is calculated using a formula that considers an employee’s salary history and years of service.
A primary difference is who assumes the investment risk. In a defined benefit plan, the employer bears all the investment risk and is responsible for contributing enough money to pay the promised benefits. If the plan’s investments underperform, the employer must make up the shortfall.
For a defined benefit plan, the funding is an ongoing liability, requiring complex actuarial calculations to meet future promises. The benefit is guaranteed, within certain limits, by the Pension Benefit Guaranty Corporation (PBGC). This guarantee is not available for defined contribution plans like SEP IRAs.