Disadvantages of SEP IRA

This article discusses the disadvantages of a SEP IRA account, along with the advantages and so much more. If you’re interested in learning everything there is to know about this type of IRA account, then you’re in the right place. Keep reading before you invest and/or make any changes to your retirement plan.

Due to the effects of the pandemic and the expansion of the gig economy, more people are choosing self-employment and entrepreneurship as a source of income. Numerous retirement savings options provided by employers might not be practical for freelancers or small-business owners.

SEP-IRA plans, thankfully, provide a creative answer that enables small-business owners to save for retirement even in the absence of a traditional employer-sponsored plan. These accounts offer non-traditional workers a way to increase their retirement savings with low fees and generous contribution limits.

What Exactly Is a SEP IRA?

A SEP IRA or Simplified Employee Pension IRA is a specialized retirement account or retirement savings plan designed specifically for business owners and self-employed individuals.

The abbreviation “SEP” stands for Simplified Employee Pension, and it’s an Individual Retirement Account tailored to this particular group.

This account largely adheres to the rules and regulations of a Roth IRA, yet it incorporates certain unique provisions that render it particularly advantageous for small-business proprietors and those working independently.

Traditional IRA vs. SEP IRA

SEP IRAs boast higher contribution limits. The SEP-IRA contribution limits must not surpass the smaller of the two amounts: 25% of their compensation or $66,000 for 2023 ($61,000 for 2022; $58,000 for 2021; $57,000 for 2020), with subsequent years being subject to adjustments based on annual cost-of-living considerations.

Contributions to a SEP IRA made by the employer are discretionary.

Solely employers possess the ability to contribute to a SEP IRA, while both employers and employees can contribute to a traditional IRA.

SEP IRAs involve notably minimal account fees.

How Does a SEP-IRA Operate?

After the establishment of a SEP-IRA, the employer proceeds to contribute a predetermined percentage to the accounts of all qualified employees.

For instance, if a business owner chose to allocate 10 percent of the CEO’s salary to the SEP-IRA within the year, a parallel 10 percent would be contributed to the SEP-IRA accounts of all other eligible employees based on their respective salaries.

Employers have the flexibility to opt for no contributions during a particular year or select a contribution percentage to assign, as long as all eligible employees receive an equivalent contribution percentage.

SEP-IRA accounts operate on a tax-deferred basis, implying that all contributions are made prior to taxation and are subject to taxation upon withdrawal from the account, typically after reaching retirement age.

Unlike certain other retirement accounts, SEP-IRAs don’t provide the option to prepay taxes during the contribution phase.

What Are the Regulations & Prerequisites for a SEP-IRA?

As a retirement plan that operates under the IRS tax code, a SEP-IRA adheres to specific rules and prerequisites that must be adhered to in order to participate in the scheme.

Failure to observe the designated SEP-IRA stipulations when initiating a plan can result in fines and penalties for the business.

Eligibility for SEP-IRA

Contributions to a SEP-IRA must be uniform for all eligible employees within the company. To qualify for SEP-IRA contributions, an employee must fulfill the following conditions:

Be at least 21 years old

Earn over $650 annually from the employer

Have completed at least three of the past five years of service with the company

Once an organization establishes a SEP-IRA through a formal agreement, all eligible employees must be offered a SEP-IRA account, unless they explicitly choose to opt out.

Since the contribution percentage for a given year must be consistent for all qualifying employees, SEP-IRA plans are particularly beneficial for businesses with a limited number of full-time employees or for self-employed individuals.

SEP-IRA Withdrawal & Distribution Regulations

The distribution regulations for SEP-IRA plans mirror the IRS restrictions governing traditional IRA plans.

Although employees cannot make contributions to a SEP-IRA, each employee retains control over their account and its funds. Withdrawals can be made at any time, but distributions taken before reaching age 59½ are generally subject to a 10 percent early withdrawal penalty.

Upon reaching age 72, employees are required to adhere to the standard rules for mandatory minimum distributions (RMDs) and must begin withdrawing minimum amounts from their SEP-IRA account. Failure to comply with the timely Required Minimum Distributions (RMDs) can lead to penalties.

SEP-IRA Contribution Guidelines & Regulations

A crucial rule concerning SEP-IRAs is that employers must maintain a consistent contribution percentage for each eligible employee.

Additional contribution rules apply to this specific type of retirement account. While employers can alter the contribution percentage annually or decide not to contribute at all, the percentage must remain uniform for all eligible employees.

Given this flexibility, many self-employed individuals and small-business owners opt for SEP-IRAs as a straightforward means to save for their retirement, benefiting from higher annual contribution limits compared to traditional IRAs.

When employers opt to contribute within a given year, they can contribute either 25 percent of each employee’s gross compensation (capped at the maximum compensation of $330,000 for 2023) or the annual maximum dollar limit set by the IRS, whichever is lower.

For 2022, the IRS set the annual contribution limits at $61,000. For 2023, the IRS raised the annual contribution limit to $66,000.

Rules on SEP-IRA Deductions

An additional advantage for employers offering SEP-IRAs is that employer contributions are tax-deductible, up to the IRS-defined SEP limits.

In cases where a business exceeds the stipulated contribution limits in an employee’s account (known as excess contributions), these amounts must be withdrawn from the employee’s SEP IRA and returned to the employer.

Such amounts are not eligible for deduction on the employer’s federal taxes. Failure to rectify excess contributions promptly could result in penalties.

Employers also have flexibility regarding the timing of a SEP-IRA tax deduction for plan contributions. Contributions made between the end of a tax year and the tax filing date can be claimed for either year.

For instance, contributions made in February 2023 can be deducted in either the 2022 tax year (if 2022 taxes have not yet been filed) or the 2023 tax year (since the contributions were made in 2023).

SEP-IRAs & Tax Implications

SEP-IRA contributions provide tax deductibility for the employer. The employer itemizes and claims eligible contributions on the annual business tax return.

Since the employer receives tax benefits and contributions are pre-tax, they are not listed on an employee’s W2 form. Tax considerations for the employee arise when withdrawals occur from the SEP-IRA account. In such cases, the account provider issues a 1099-R to the employee to report any taxable distributions.

Establishing a SEP-IRA

If you determine that a SEP plan suits your business, the setup process is relatively straightforward.

Complete formal written agreement paperwork to initiate the SEP-IRA

This often involves filling out IRS Form 5035-SEP, though IRS-approved alternatives or individual formal agreement documentation can serve as substitutes for Form 5035-SEP. The completed paperwork is retained by the employer as official notice for all eligible plan participants.

Communicate Plan Details to all Eligible Employees

SEP-IRA regulations mandate a consistent contribution percentage for all eligible employees. You can share this information by providing a copy of IRS Form 5035-SEP or equivalent documentation containing eligibility criteria, contribution details, and instructions for managing their accounts.

Select a SEP-IRA Provider and Establish Accounts for Eligible Employees

Numerous brokers or account providers can create individual accounts for you and your employees, each with varying investment options, fee structures, and account minimums. Evaluate and compare provider offerings, then proceed with setting up the required accounts through your chosen provider.

Pros and Cons of SEP-IRAs

SEP retirement plans offer advantages for both employers and employees, but there are also some drawbacks to consider. To determine whether a SEP-IRA aligns with your business needs, it’s important to weigh the following benefits and drawbacks:

Advantages of SEP-IRAs:


Setting up and managing SEP-IRAs is straightforward for both employers and employees.

Tax Benefits

Contributions are tax-deferred for employees, reducing their immediate tax liability, and they are tax-deductible for the business, potentially lowering its taxable income.

Higher Contribution Limits

SEP-IRAs permit higher annual contribution limits compared to traditional IRAs, allowing for more substantial retirement savings.

Flexible Contributions

Employers have the flexibility to adjust contribution percentages from one year to the next, accommodating varying business conditions.

Retirement Benefits

SEP IRAs offer retirement benefits that involve equal contributions, fostering a sense of financial security for participants.

Tax Advantages

These plans come with tax advantages similar to those associated with Roth IRAs, granting participants potential tax savings.

Simplified Employee Pension Plan

SEP IRAs are a form of a Simplified Employee Pension plan, designed to provide streamlined retirement solutions for employees.

By utilizing SEP IRA accounts, individuals can tap into these advantages to secure a more stable retirement future.

Disadvantages of a SEP-IRA

No Employee Contributions

Unlike some retirement plans, SEP-IRAs do not allow employees to make their own contributions, which means the savings burden falls solely on the employer.

No Catch-Up Contributions

For employees approaching retirement age, there is no provision for catch-up contributions, potentially limiting their ability to bolster their savings.

Early Withdrawal Penalty

Withdrawals made before age 59½ from a SEP-IRA are typically subject to a 10 percent tax penalty for the employee, discouraging premature access to mutual funds.

In weighing these pros and cons, businesses can make an informed decision about whether a SEP-IRA is a suitable retirement savings option for their workforce and financial goals.

Final Thoughts

While SEP IRAs offer several advantages such as simplicity in setup and management, tax benefits through deductible contributions, and higher contribution limits compared to traditional IRAs, there are certain disadvantages to consider.

Notably, SEP IRAs don’t allow employee contributions and lack catch-up contribution provisions for those nearing retirement. Additionally, early withdrawals from SEP IRAs before the age of 59½ may incur a tax penalty.

Businesses interested in offering a retirement plan like the Simplified Employee Pension (SEP) should carefully weigh these factors against the benefits of tax-deductible contributions, higher contribution limits, and the flexibility that SEP IRAs can provide as part of their employees’ retirement savings strategy.