According to the U.S. Bureau of Labor Statistics, 86% of private-sector companies with 100 or more workers and 91% of firms with 500 or more workers offered a retirement benefit plan in 2023. For small businesses—those with fewer than 100 employees, that percentage dropped to 57%. Still, there’s a desire on the part of small businesses to offer a retirement plan as a way to compete in the job market and help their staff save for the future. And self-employed individuals who want to ensure their retirement future probably want a retirement plan too. One of the key choices for small employers and self-employed individuals is a SEP. Here are some important things to keep in mind in deciding whether to use a SEP for your business and how to distinguish them from regular IRAs.
Overview of SEPs
As qualified retirement plans go, a SEP, which stands for Simplified Employee Pension, has a lot going for it. You can save substantial sums and take large deductions for contributions, assuming your earnings are high. You don’t have to file any annual information returns with the Department of Labor as you do for profit-sharing plans and 401(k)s. But if you have employees, it is the business that makes all contributions on their behalf.
SEPs are often lumped in with regular IRAs. But just because a SEP looks and feels like an IRA—even the form for establishing it is called a SEP-IRA—the tax law doesn’t treat it as such in some respects. Whether they’re treated like IRAs may be favorable or unfavorable, depending upon the issue involved.
Like an IRA
Borrowing. A qualified retirement plan can allow a participant to borrow from his or her account (assuming the plan permits it), but a SEP cannot allow this. In this respect, a SEP is like an IRA. Like regular IRAs, borrowing from a SEP is a prohibited transaction that causes the account to lose its tax-exempt status. If you borrow from a SEP, all of the funds in the account become immediately taxable to you. There are also penalties. This is unfavorable.
Delayed RMDs. Required minimum distributions (RMDs) from a qualified plan that normally must begin at age 70½ can be postponed until retirement for a participant who is not a more-than-5% owner of the business. Like regular IRAs, this rule does not apply to SEPs. Distributions must commence after this age regardless of whether a participant owning 5% or less is still employed. This is unfavorable.
Divorce. In the case of divorce, in order to transfer funds from a qualified plan to an ex-spouse without tax cost to the participant, there must be a court-issued qualified domestic relations order (QDRO). But a SEP is treated like an IRA for transfers related to divorce. As long as a transfer to a former spouse is “incident to divorce,” the owner (transferor-spouse) isn’t taxed. The transfer must be direct (no distribution to the SEP owner) or done via a title change on the account. This is favorable.
Early distributions. Distributions from a qualified retirement plan before age 59½ escape penalty in limited circumstances. There are many more penalty exceptions for IRAs; these apply as well to SEPs (see the IRS chart on penalty exceptions). For example, there’s no penalty for early withdrawals to pay qualified higher education expenses, first-time homebuyer costs, and medical insurance while unemployed. These exceptions don’t apply to 401(k)s and other qualified retirement plans. This is favorable.
Asset protection not involving bankruptcy. Assets held in a qualified retirement plan enjoy maximum protection against the claims of creditors because there’s an anti-alienation provision in the Employee Retirement Income Security Act of 1974 (ERISA). This federal law does not apply to assets in an SEP (the same treatment for regular IRAs), although state law might. This is unfavorable.
Not like an IRA
Contribution limits and catch-ups. Contributions to SEPs are comparable to those in profit-sharing plans. For example, the maximum contribution for to SEP in 2024 is $69,000. In contrast, the maximum IRA contribution in 2024 is $7,000. There’s a catch-up contribution amount for IRAs of $1,000. There are no catch-up contributions in SEPs. But overall, the amount that can go into a SEP is substantially higher than an IRA for those with sufficient earnings. This is favorable.
Roths. Starting last year, SEPs could offer a Roth feature, allowing contributions to be designated as taxable, but earnings on contributions to build up tax free. For IRAs, if a Roth—an after-tax savings plan—is desired, it has to be a separate account. But the good thing here is that there is no income limit on designating the Roth contribution in a SEP, in contrast to income limits for making contributions to a Roth IRA. This is unfavorable for the separate account requirement, but favorable for the omission of an income limit for contributions.
Qualified charitable distributions (QCDs). IRA owners age 70 ½ can make tax-free transfers directly to public charities up to $105,000 in 2024. (The $105,000 limit can be adjusted for inflation for 2025.) QCDs count toward required minimum distributions (RMDs), effectively making them tax free. However, QCDs cannot be used for SEPs as long as they’re still being funded. So, a self-employed individual working after age 70 ½ who continues to add contributions to a SEP cannot use the account for QCDs. Distributions from employer-sponsored retirement plans, including active SEPs, are not eligible for this tax rule. This is unfavorable.
Bankruptcy protection. Under the federal Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, an unlimited amount of assets in SEPs are shielded in case of bankruptcy, in contrast to a $1.51 million limit for 2024 of assets in IRAs. This is favorable.
Final thought
Small businesses that want to provide a retirement plan have many choices. The IRS has a guide entitled Choosing a Retirement Plan Solution for Your Small Business to help. If you are considering a SEP, be aware of how it is similar to or different from an IRA.
For additional information on retirement planning, see this list of blogs.
