What Are the Disadvantages of a SEP IRA?

A Simplified Employee Pension (SEP) IRA is a retirement plan commonly used by self-employed individuals and small business owners. It is known for its straightforward setup and the capacity for high annual contributions. However, a SEP IRA also has several distinct disadvantages that can make it a less-than-ideal choice for certain business structures and savings goals. The plan’s inflexible rules surrounding contributions, limited account features, and specific restrictions for older savers are significant drawbacks.

Strict Contribution and Employee Rules

A primary disadvantage of the SEP IRA is its rigid framework for contributions, which are funded exclusively by the employer. Employees are not permitted to make their own salary deferral contributions to their accounts. This employer-only funding model means an employee’s ability to save for retirement is entirely dependent on the employer’s decision to contribute in any given year.

The most significant financial constraint is the mandatory and uniform contribution rule. If a business owner decides to make a contribution to their own SEP IRA, they are required to contribute to the accounts of every eligible employee. The contribution must be the same percentage of compensation for everyone. For instance, if a business owner with a salary of $200,000 contributes 10% for themselves ($20,000), they must also contribute 10% of compensation for every eligible employee, an expense that can become substantial for businesses.

This plan’s eligibility rules are broad and can encompass part-time workers, adding to potential costs. An employee must be included in the plan if they are at least 21 years old, have worked for the business in three of the last five years, and earned at least $750 for 2024. Another drawback is that all employer contributions are 100% vested immediately. This means the employee owns the funds as soon as they are deposited and can take the full amount with them if they leave the company, reducing the plan’s utility for employee retention.

Limited Account Features

SEP IRAs lack some of the modern features found in other retirement plans, which can limit savings strategies. One of the most notable omissions is the absence of a Roth contribution option. All contributions to a traditional SEP IRA are made on a pre-tax basis, meaning the money is tax-deductible for the business and grows tax-deferred. While the SECURE 2.0 Act introduced the possibility for a Roth SEP IRA, it is not a required feature and many financial institutions do not yet support it.

The lack of a readily available Roth option means participants cannot make after-tax contributions for tax-free withdrawals in retirement. This restricts tax diversification, as all withdrawals from a traditional SEP IRA are taxed as ordinary income. This is a considerable disadvantage for individuals who anticipate being in a higher tax bracket in retirement or want a source of tax-free income.

Another limitation is that participants are not permitted to take loans from their SEP IRA accounts. This is in contrast to 401(k) plans, where loans are a common feature allowing participants to borrow up to 50% of their vested balance (up to $50,000). For those needing liquidity, the only way to access funds from a SEP IRA is through a withdrawal. A withdrawal is a taxable event and, if the participant is under age 59 ½, will generally trigger an additional 10% early withdrawal penalty.

No Catch-Up Contributions

A drawback that impacts older participants is that SEP IRAs do not permit catch-up contributions. Retirement plans like the 401(k) and SIMPLE IRA have a provision that allows individuals aged 50 and over to contribute an additional amount above the standard annual limit.

For 2024, participants in a 401(k) plan who are age 50 or older can contribute an extra $7,500 as a catch-up contribution. A SEP IRA does not have an equivalent provision. While the overall contribution limit for a SEP IRA is high—the lesser of 25% of compensation or $69,000 in 2024—the inability to add this specific catch-up amount can be a limiting factor for those behind on retirement savings.