SEP-IRA
SEP-IRA is a retirement plan for self-employed individuals and small businesses, allowing employer contributions of up to 25% of compensation (or 20% of net self-employment income for sole proprietors) up to a 2024 maximum of $69,000 per year.
SEP-IRAs are the simplest meaningful retirement plan for self-employed individuals — no plan document required, contributions are made with the same flexibility as a tax-deductible IRA contribution, and the contribution limit is much higher than traditional IRA limits. For freelancers, consultants, and small business owners with no employees other than themselves, the SEP-IRA is often the right starting point.
The trade-off versus a Solo 401(k) is contribution capacity at lower income levels. The SEP-IRA contribution is limited to 20-25% of compensation, with no employee-deferral component. The Solo 401(k) allows both an employee deferral (up to $23,000 in 2024) and an employer contribution (up to 25% of compensation), so a self-employed person earning $100K could contribute roughly $43K to a Solo 401(k) but only $20K to a SEP-IRA.
For businesses with employees, SEP-IRAs become less attractive because all eligible employees must receive the same percentage contribution. A business owner who wants to contribute 20% of their own compensation must contribute 20% of every employee's compensation — making the plan expensive once the employee count grows. Most growing small businesses transition from SEP-IRA to a 401(k) as employee count increases.
| SEP-IRA | Solo 401(k) | |
|---|---|---|
| Plan document required | No (Form 5305-SEP) | Yes (custom or prototype) |
| Employee deferral | Not allowed | Up to $23,000 (2024) |
| Employer contribution | Up to 25% of comp (20% effective sole prop) | Up to 25% of comp |
| Combined max (2024) | $69,000 | $69,000 + $7,500 catch-up if 50+ |
| Roth option | No | Yes (employee deferral; some plans support after-tax + in-plan conversion) |
| Form 5500 filing | None | Required at $250K+ plan assets |
| Employees treatment | Must contribute same % for all eligible employees | Cannot include non-spouse employees (would force conversion to regular 401(k)) |
SEP-IRA test data needs the self-employment-income computation chain: gross self-employment income → less ½ SE tax → less SEP contribution itself (circular for sole proprietors). The IRS uses a 20% effective rate for sole proprietors, not the 25% headline number, because the contribution is itself a deduction from the base. Multi-employee SEP scenarios need per-employee eligibility flags (age 21+, 3-of-prior-5-years service, $750+ comp) and the equal-percentage allocation across all eligible employees. The pro-rata rule for backdoor Roth conversions binds heavily on households with SEP-IRA balances — engines must track aggregate IRA basis across SEP, SIMPLE, and Traditional pre-tax balances.
Common pitfalls
- Applying 25% to gross self-employment income instead of 20% to net. The compounding-circular nature of the calculation yields 20% effective for sole proprietors; engines using 25% over-state the contribution by ~25%.
- Forgetting the equal-percentage rule on multi-employee plans. SEP contributions must be the same percentage of compensation for all eligible employees; owners cannot self-favor.
- Including SEP balance in backdoor-Roth pro-rata math without flagging the consequence. A household with a $50K SEP-IRA cannot cleanly execute a backdoor Roth without recognizing the pro-rata share of pre-tax basis as taxable on conversion.
- Modeling SEP contributions as employee deferrals. SEP is employer-only; the contribution does not show on the participant's W-2 box 12 or affect their elective-deferral limits across plans.
Examples
Sole proprietor with $120,000 of net self-employment income. SE tax: ~$16,950. ½ SE tax deduction: ~$8,475. Net earnings from self-employment: $111,525. SEP contribution (20% effective): ~$22,305. The owner cannot contribute $30,000 (25% of gross); the IRS-published rate-table for sole proprietors yields ~18.6% of net earnings as the effective max for a 25%-rate SEP, with the difference reflecting the circular self-deduction.