SEP IRA vs. Traditional IRA: Key Differences

Navigating the world of retirement savings can present a complex landscape of options. For individuals, and especially for those who are self-employed or own a small business, understanding these options is an important part of financial planning. Two prominent choices are the Simplified Employee Pension (SEP) IRA and the Traditional Individual Retirement Arrangement (IRA).

While both are designed to build a nest egg, they function very differently. The SEP IRA is a tool for business owners to save for themselves and their employees, whereas the Traditional IRA is a personal savings vehicle available to almost anyone with earned income. This article will explore the distinctions between these two retirement accounts.

Defining the SEP IRA

A Simplified Employee Pension (SEP) IRA is a retirement plan designed for self-employed individuals and small-business owners. Its structure offers a way to make substantial retirement contributions without the administrative complexity and costs of more conventional employer-sponsored plans. The plan is established by the business, not the individual employee.

The primary characteristic of a SEP IRA is its funding source. Contributions are made exclusively by the employer; employees are not permitted to contribute via salary deferrals. For a self-employed individual, this means they act as both the “employer” and the “employee,” making contributions from their business earnings. If the business has other eligible employees, the employer must contribute the same percentage of compensation for them as they do for themselves.

This employer-only contribution model provides flexibility. The business owner can decide each year whether to make a contribution and can vary the amount based on the business’s financial performance. There is no annual requirement to fund the plan, which is advantageous for businesses with fluctuating income. All contributions made to a SEP IRA are immediately 100% vested, meaning the funds belong entirely to the employee as soon as they are deposited.

Defining the Traditional IRA

A Traditional Individual Retirement Arrangement (IRA) is a personal retirement account that allows individuals with earned income to save for the future with tax-deferred growth. Unlike a SEP IRA, a Traditional IRA is opened and funded by the individual account holder. This type of account is widely accessible and serves as a retirement savings tool for many people, whether they are employed by a company, self-employed, or have a working spouse.

The account holder is responsible for depositing funds into their own account, up to a specified annual limit set by the Internal Revenue Service (IRS). These contributions are often made with pre-tax dollars, meaning they may be tax-deductible, which can lower the individual’s current taxable income. The money within the account then has the potential to grow without being taxed on interest, dividends, or capital gains each year.

This structure is beneficial for individuals who anticipate being in a lower tax bracket during retirement than they are in their peak earning years. By deferring the tax liability, savers can pay taxes at a lower rate when they begin withdrawing funds. The account is available to anyone with qualifying earned income, though income can affect the tax deductibility of contributions.

Contribution Rules and Limits

For a SEP IRA, only the employer contributes. These contributions are based on a percentage of employee compensation, with the employer having the discretion to contribute up to 25% of compensation, not to exceed a specific annual dollar limit. For self-employed individuals, this calculation is based on net adjusted self-employment income, meaning the effective contribution rate is closer to 20% of their net earnings. For 2025, the overall contribution limit is $70,000.

Traditional IRA contributions are made by the individual account holder and are subject to a much lower flat-dollar limit. For 2025, an individual can contribute up to $7,000. A feature of the Traditional IRA is the “catch-up” contribution, which allows individuals age 50 and over to contribute an additional $1,000, bringing their total possible contribution to $8,000 for 2025. SEP IRAs do not have a similar catch-up provision.

The deadlines for making contributions also differ. For a Traditional IRA, contributions for a specific tax year must be made by the federal tax filing deadline, typically April 15 of the following year, with no extensions allowed for this purpose. A SEP IRA offers more flexibility, as contributions can be made up until the business’s tax filing deadline, including any extensions. This means a business owner who files an extension could make SEP IRA contributions for the prior year as late as October 15.

Eligibility Requirements

Eligibility for a SEP IRA is directly tied to business ownership or self-employment. Sole proprietors, partnerships, and corporations can establish a SEP plan. An individual who earns freelance or side-hustle income can also open a SEP IRA for themselves. If a business owner with a SEP plan has employees, they must include any employee who is at least 21 years old, has worked for the business in at least three of the last five years, and has received at least $750 in compensation for the year. The employer has the option to use less restrictive participation requirements but cannot make them more restrictive.

Eligibility for a Traditional IRA is broader. The primary requirement is that the individual, or their spouse if filing a joint tax return, must have taxable compensation, also known as earned income. This includes wages, salaries, commissions, and self-employment income. There is no age limit for contributing, and eligibility is not dependent on being a business owner.

Tax Implications and Withdrawal Rules

Contributions to a SEP IRA are made by the business and are claimed as a tax-deductible business expense on the business’s tax return, which reduces the business’s taxable profit. For the employee, including a self-employed individual, these employer contributions are not included in their current taxable income. For a Traditional IRA, contributions are made by the individual and may be tax-deductible on their personal tax return. This deduction can be limited or eliminated if the individual or their spouse is covered by a retirement plan at work and their modified adjusted gross income (MAGI) exceeds certain IRS thresholds.

The withdrawal rules for both plans are similar. Distributions from both SEP IRAs and deductible Traditional IRAs are taxed as ordinary income in the year the withdrawal is made. Withdrawals taken before age 59½ are subject to a 10% early withdrawal penalty in addition to regular income tax, though certain exceptions for events like disability or a first-time home purchase can apply. Both account types are also subject to Required Minimum Distribution (RMD) rules, which mandate that withdrawals must begin after the account owner reaches a certain age. This age is 73, but it is scheduled to increase to 75 for individuals born in 1960 or later.