SEP IRA: How It Works for Self-Employed Savers

A Simplified Employee Pension (SEP) IRA is a retirement account that allows self-employed individuals and small business owners to make tax-deductible contributions on behalf of themselves and eligible employees. It was created by Congress in 1978 to give small businesses a straightforward alternative to complex pension plans.

The key features:

• Contribution limit: Up to 25% of net self-employment income, capped at $70,000 for 2026
• Tax treatment: Contributions are tax-deductible; growth is tax-deferred; withdrawals in retirement are taxed as ordinary income
• Eligibility: Any self-employed individual or business owner — sole proprietors, freelancers, independent contractors, partnerships, S-corps, C-corps
• Simplicity: No annual IRS filing requirements (unlike a 401(k) which requires Form 5500)
• Deadline: Contributions can be made until your tax filing deadline, including extensions — as late as October 15 for calendar-year filers

The SEP works like a traditional IRA on steroids. Your money goes in pre-tax, grows tax-deferred, and you pay ordinary income tax when you withdraw in retirement. Required minimum distributions begin at age 73, just like a traditional IRA.

The contribution formula trips up a lot of people. Here's how it actually works:

For sole proprietors and single-member LLCs, the effective contribution rate is approximately 20% of net self-employment income (not 25%), because you must reduce your net income by one-half of your self-employment tax before calculating the 25% limit.

The calculation:

1. Start with net self-employment income
2. Subtract the deductible portion of self-employment tax (7.65% of net income, roughly)
3. Multiply the result by 25%

Example: If your Schedule C shows $200,000 in net profit:

• Self-employment tax deduction: ~$14,130
• Adjusted net: $185,870
• SEP contribution: 25% × $185,870 = $46,468

That's effectively 23.2% of your gross net income — not 25%. Still far more than the $7,000 traditional IRA limit.

For S-corp owners, the calculation is simpler: 25% of your W-2 salary from the S-corp. If you pay yourself $120,000 in salary, you can contribute up to $30,000.

This is the question every self-employed person should ask. The answer depends on your income level and whether you want a Roth option.

SEP IRA wins when:

• You want zero administrative hassle — no annual filing, no plan document updates
• Your income is high enough that the 25% employer contribution maxes out at or near $70,000
• You have no employees (or only want to cover yourself)
• You value the extended contribution deadline (up to October 15 with extension)

Solo 401(k) wins when:

• Your income is moderate ($50,000-$150,000) — the employee deferral component lets you save more at lower income levels
• You want a Roth option — Solo 401(k)s allow Roth employee deferrals; SEP IRAs do not
• You want to take a 401(k) loan against your balance
• You're over 50 and want catch-up contributions ($7,500 extra for 2026)

The crossover point: At roughly $280,000 in net self-employment income, both accounts hit the $70,000 ceiling. Below that income level, a Solo 401(k) typically lets you contribute more because of the employee deferral. Above it, they're equivalent — and the SEP's simplicity becomes its edge.

One critical difference: if you have a SEP IRA and want to do a Roth conversion from a traditional IRA, the SEP balance counts in the pro-rata calculation. This can make backdoor Roth conversions expensive. A Solo 401(k) avoids this problem because 401(k) balances are excluded from the pro-rata rule.

Here's where SEP IRAs get expensive for employers. If you have W-2 employees who meet the eligibility criteria (age 21+, worked for you in 3 of the last 5 years, earned at least $750), you must contribute the same percentage of compensation for every eligible employee as you contribute for yourself.

That's not optional. If you contribute 20% of your own income, you must contribute 20% of every eligible employee's pay too. There's no vesting schedule — contributions are immediately 100% vested.

Example: You earn $200,000 and have two employees earning $60,000 each. If you contribute 20% for yourself ($40,000), you must also contribute 20% for each employee ($12,000 each). Your total cost: $64,000, of which $24,000 goes to employees.

This is why many small business owners with employees switch to a SIMPLE IRA or a traditional 401(k) with a vesting schedule. The SEP's equal-contribution requirement makes it impractical for businesses with more than a handful of employees.

Who qualifies as eligible: Employees who are at least 21 years old, have worked for you in at least 3 of the last 5 years, and received at least $750 in compensation during the year. You can use less restrictive requirements but not more restrictive ones.

Setting up a SEP takes about 15 minutes — far simpler than a 401(k).

Step 1: Complete IRS Form 5305-SEP — This is a one-page plan document. You don't file it with the IRS; you keep it for your records. Most brokerages handle this automatically during account opening.

Step 2: Open the account — Any major brokerage offers SEP IRAs: Fidelity, Schwab, Vanguard, Interactive Brokers. No account fees at most providers. The account holds the same investments as any IRA — stocks, bonds, ETFs, mutual funds.

Step 3: Fund it — You can contribute anytime during the tax year, up to your tax filing deadline (including extensions). Many self-employed people make their SEP contribution in early April when they see their final Schedule C numbers.

Step 4: Invest — A diversified portfolio appropriate for your time horizon. For those decades from retirement, a simple three-fund portfolio (total US stock market, international stocks, bonds) works well. As you approach retirement, increasing the bond allocation — including Treasury securities and TIPS — provides stability.

Important: SEP IRA contributions are reported on your tax return (Schedule 1, Line 16 for sole proprietors) but there's no separate annual plan filing with the IRS. This is a major advantage over 401(k) plans, which require annual Form 5500 filings once assets exceed $250,000.