How Does A SEP-IRA Work And What Are The Contribution Limits

A SEP-IRA lets employers (including self-employed individuals) make tax-deductible contributions directly into an employee's traditional IRA, up to 25% of compensation or a $69,000 maximum for 2024. Crucially, if you are self-employed, you can only contribute roughly 20% of your net earnings due to a special calculation that accounts for self-employment tax.

How sep ira rules govern employer contributions

Unlike a 401(k) where you split your paycheck into pre-tax deferrals, a SEP-IRA is funded entirely by the employer. For a W-2 employee, your company writes a check directly to your SEP-IRA account. You never see that money as taxable wages. For a sole proprietor or single-member LLC, you are both the boss and the worker. You fund the account from your business bank account into a SEP-IRA opened in your own name. The employer decides each year whether to put money in and how much. The amount can range from zero up to the legal ceiling. There is no requirement to add funds in a loss year. This annual flexibility makes SEP-IRAs popular for businesses with volatile revenue. But it also means you cannot play catch-up with missed years. Each year stands alone.

One critical mechanic: employees cannot make salary deferrals into a SEP-IRA. This differs from a 401(k) where you elect to set aside a percentage of each paycheck. The only money that enters a SEP-IRA is the employer’s pre-tax deposit. It vests immediately. You also cannot take a loan from a SEP-IRA. Distributions before age 59½ face the same 10% early withdrawal penalty as a traditional IRA. The account itself is a standard traditional IRA. Once the money lands inside, it grows tax-deferred. You pay ordinary income tax on withdrawals in retirement.

The 25% limit and the self-employed calculation

The most common error freelancers make is assuming they can put 25% of their gross business income into the plan. That flat 25% rate applies only to W-2 employees of a company. The employer calculates the deposit based on taxable wages reported on a W-2. For a self-employed person, the IRS forces you to reduce your net profit by two things before applying the percentage. First, subtract half of your self-employment tax. Second, subtract the SEP-IRA deposit itself. Because the deposit is a percentage of the reduced amount, you end up with an effective rate of 20% of your net profit, not 25%. Confirm your exact limit using the IRS’s worksheet in Publication 560, available at IRS.gov.

Here is the concrete math. Suppose your sole proprietorship shows a net profit on Schedule C after all business expenses. The IRS sets annual contribution caps, so check the current year’s limit at IRS.gov. First, subtract half of self-employment tax from that profit. Then apply the 20% rate to that reduced figure to find your maximum deposit. If you incorrectly used 25% on the original profit, you would exceed the legal limit and trigger excise taxes. The shortcut is to multiply net profit by 20% after subtracting half of SE tax. This same reduced-rate logic applies when comparing solo 401(k) vs sep-IRA plans. The 401(k) lets you deposit funds as an employee, which changes the math entirely.

Annual dollar caps and deadlines

The IRS sets an absolute maximum contribution each year, along with a compensation cap used for the calculation. Visit IRS.gov for the current limits, as these figures adjust annually. A self-employed person with high net profit would calculate 20% of the reduced amount after SE tax. Only someone earning above the compensation cap would hit the dollar limit. Then the deposit is simply capped at the IRS maximum.

The deadline to set up and fund a SEP-IRA is the same as your tax filing deadline, including extensions. Open and fully fund your SEP-IRA as late as October 15 if you filed an extension. This gives you months after year-end to decide how much to save. Unlike a SIMPLE IRA or 401(k), there are no employee notices or annual filing requirements if you are the only participant. This makes it the cheapest and simplest plan to administer. For a solo founder comparing sep-IRA vs simple IRA, the SEP wins on higher contribution limits. The SIMPLE allows employee salary deferrals if you have staff. When you weigh self-employed retirement plans like a SEP against a solo 401(k), the SEP is easier to set up. The 401(k) allows an extra employee-deferral on top of the profit-share. This can boost your total savings above the IRS dollar cap if you earn enough.

Frequently asked questions

Can I put money into a SEP-IRA and a Roth IRA in the same year?

Yes. The SEP-IRA deposit counts as employer money and does not reduce your personal Roth IRA limit. Your Roth eligibility depends on your modified adjusted gross income. High earners may still face income caps.

What happens if I put too much into my SEP-IRA?

Excess amounts face a 6% excise tax each year until you remove the overage. Withdraw the excess plus any earnings by the tax filing deadline, including extensions, to avoid the penalty.

Do I need to file a separate tax return for my SEP-IRA?

No. Report your deposits on your personal Form 1040 using Schedule 1. The deduction flows to your business tax forms. Skip the separate trust or annual filing unless you have other employees or your plan assets exceed the IRS threshold. Check the current asset reporting trigger at IRS.gov.

Can I switch from a SEP-IRA to a solo 401(k) mid-year?

Yes. Open a solo 401(k) at any time. Close the SEP-IRA or stop making new deposits to it before using the 401(k) for the same tax year. Roll over existing SEP-IRA funds into the 401(k) by following the plan document’s rules.

Unlike a 401(k), a SEP-IRA cannot receive employee salary deferrals, which means every dollar inside the account must come from an employer profit-share deposit that is always pre-tax and vests immediately. For a fuller picture of how this account fits into your broader strategy, see the companion guide, Self-Employed Retirement Plans: What to Know and How to Handle It, which covers the full range of self-employed retirement plans.