Understanding SEP IRA Rules

SEP IRA plans offer flexibility that other retirement plans do not. Here’s what to consider when it comes to SEP IRA rules.


An IRA, or Individual Retirement Account, is a type of retirement savings account that lets you defer taxes on contributions and earnings until you withdraw the money at retirement. Any person can open a traditional IRA and make contributions, but employers can’t contribute to traditional IRAs on an employee’s behalf unless it’s been given the SEP designation. An SEP IRA (Simplified Employee Pension) is an IRA that’s funded by an employer. The employer gets to take a tax deduction for contributions made to an employee’s SEP IRA.

Employers may choose to have an SEP plan versus other types of qualified plans, like a 401(k), because the SEP is easier and cheaper to start and maintain. The employer doesn’t have to contribute the same amount of money every year and can even choose not to contribute money in some years. Employers can also have an SEP plan in addition to other retirement plans.

Who Can Establish an SEP IRA?

All employers with at least one employee are able to establish an SEP plan, even if the only employee is the employer himself. That means self-employed business owners can open SEP IRAs for themselves. The IRS allows you to set up an SEP IRA for your self-employment income even if you participate in another employer’s retirement plan.

An employee who wants to participate in the SEP plan has to first open a traditional IRA, and then have the financial institution give the IRA a SEP designation. Then the employer can make SEP contributions. The SEP should be set up by that year’s tax return due date, e.g. April 15 if you follow the calendar year.

SEP IRA Contribution Limits

Each year, the employer can contribute a maximum of $49,000 (for 2010 and 2011) or 25% of the employee’s compensation (including bonuses and overtime), whichever is less. Compensation over $245,000 isn’t considered. SEP IRA contribution limits state that
employers can choose to contribute the same percentage of compensation to all eligible employees. They can also contribute a flat dollar amount. Or, employers contribute a larger percentage to higher-paid employees. The $49,000 contribution maximum applies to retirement plans the employer may contribute to.

Employees can continue to make contributions to the SEP IRA as long as the plan permits, even while an employer makes contributions. Employer contributions don’t affect the employee’s allowable contribution amount, which is $5,000 for those under age 50 and $6,000 for those over age 50. But, if an employee does contribute to an SEP IRA, they may not be able to deduct the contributions from their taxes the way they can with a traditional IRA.

Employee Elective Deferrals

Some SEPs created before 1997 allowed employees to make tax-deferred contributions. These Salary Reduction Simplified Employee Pension (SARSEP) plans are only available when 50% of employees make elective deferrals and less than 25 employees are eligible. Under a SARSEP, employees can contribute up to $16,500 or 25% of their compensation, whichever is less.

Setting up an SEP IRA

The employer has to follow three SEP IRA rules to set up an SEP plan:

1) Create a formal written agreement. The employer can use the IRS’ SEP form – Form 5305-SEP, or they can create their own. Employers must use a prototype SEP from the bank or design their own SEP if the company offers another type of retirement plan other than a SEP.
2) Notify every eligible employee of the SEP and include the Form 5305-SEP if it was used to establish the plan.
3) Set up a SEP-IRA for every employee that’s eligible. The employee should maintain control of the account and the employer can make contributions to it.

Employees are generally able to participate in the SEP plan as long as they are at least age 21, have worked for the employer any amount in at least three of the last five years, and have been paid at least $550 in 2010 and 2011. Employers are allowed to change these requirements as necessary, especially to make sure the employer is able to participate in program.