SEPs Remain a Valued Retirement Plan Option
By Mike Rahn, CISP
The simplified employee pension, or SEP, is a retirement plan that—like the Energizer bunny of TV commercial fame—just “keeps going and going and going.” That’s because the retirement saving niche SEPs have occupied since their creation by the Revenue Act of 1978 remains a substantial one. SEPs may not have as many bells and whistles as some retirement plans. And such factors as a business owner’s compensation may dictate which retirement plan can deliver the “biggest bang” in total saving opportunity. But for many business owners, the SEP’s combination of simplicity, administrative ease, and contribution potential are still a winning combination.
U.S. retirement plans began as a benefit generally provided by larger corporate employers. The self-employed, and smaller unincorporated businesses, did not have an option tailored to them until enactment of the Self-Employed Individuals Tax Retirement Act of 1962, better known as the Keogh Act, H.R. 10, named for sponsoring lawmaker Rep. Eugene Keogh of New York.
But it was not until 16 years later that the Revenue Act of 1978 took the simplifying step of linking an employer retirement saving option to a Traditional IRA, the individual retirement saving arrangement that itself was only four years old, created by the Employee Retirement Income Security Act (ERISA) of 1974. This has been a convenient marriage, with all SEP contributions residing in an employee’s own IRA, and treated like any other IRA asset thereafter.
Like a Profit Sharing Plan, But Simpler
Some have described the SEP as a poor man’s profit sharing plan. Both can deliver an employer contribution up to 25 percent of compensation, the same as other defined contribution plans, including a 401(k), money purchase, or target benefit plan. (Before the 2001 enactment of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), this limit was 15 percent.) If the sponsoring employer has common-law employees, and if SEP contributions for the year are made (they are always discretionary), they are generally allocated on a pro rata basis, based on all eligible individuals’ annual compensation.
The compensation that can be considered for contribution purposes is limited to the “compensation cap,” an amount that is adjusted annually based on cost-of-living adjustments ($350,000 for 2025 and $360,000 for 2026). It should be noted that an allocation formula other than pro rata can be used, but this happens infrequently in SEP plans.
Unlike profit sharing plans, which require employers to file Form 5500 with the DOL or IRS, there is no plan-level government reporting; only ordinary IRA reporting at the employee level.
What a SEP Plan Lacks
While both SEP and profit sharing plans have the same maximum employer contribution amount of 25 percent of compensation, it may be harder for an employer with a SEP to finely tune an employee’s eligibility, or his entitlement to the employer’s contributions. For instance, an employer with a SEP plan cannot require that an annual hours-of-service minimum be met in order to receive a benefit. It can, however, require employees to be at least 21 years old, have worked at the company in three of the previous five years, and meet a very low minimum earnings requirement in each of those prior years and in the current year ($750 for 2025 and $800 for 2026).
Union employees for which retirement benefits have been the subject of good faith bargaining, and nonresident aliens with no U.S.-source earned income, can also be excluded.
In addition, an employer with a SEP cannot apply a vesting schedule to contributions that an employee has already received, by requiring continued employment for a defined period in order to receive all allocated employer contributions. More sophisticated contribution allocation formulas—such as new-comparability, or age-weighted formulas—are also unavailable in SEP plans.
But perhaps the most important feature that a SEP plan established today lacks is the ability for an employee or owner to make salary deferrals from their own pay, a feature that a 401(k) or 403(b) plan allows.
A salary deferral option was available in SEP plans for firms with 25 or fewer employees after the Tax Reform Act of 1986 (TRA-86). Eligible employees and owner-employees could make salary deferral contributions to the same extent permitted in 401(k) and 403(b) plans. No match on employee deferrals was permitted.
In practice, it was common for employers to establish two SEP arrangements, one enabling the employer contribution—some calling this a “standard” SEP—as well as a deferral arrangement under SAR-SEP documentation. These combined contributions could not exceed a fixed amount each year, known as the annual additions limit, which was, and is today adjusted annually as cost-of-living indices dictate (its $70,000 for 2025 and $72,000 for 2026).
To the disappointment of some, the SEP salary deferral option was eliminated when SIMPLE IRA and SIMPLE 401(k) plans were created by the Small Business Job Protection Act of 1996. Only those SAR-SEP plans established in 1996, or before, may remain in operation. Few SAR-SEPs are believed to exist today.
Today’s SEP May be Ideal for the Owner-Only Business
If a broad generalization can be made, it is typical for employers with common-law employees to establish retirement plans that are funded primarily with employee salary deferrals, with perhaps a limited matching and/or profit sharing contribution to add to those employee deferrals. For this reason, SIMPLE IRA plans and safe harbor-design 401(k) plans dominate the small plan marketplace.
Conversely—because SEP and stand-alone profit sharing plans are funded entirely with employer contributions—it is common for them to be established by business owners who have no common law employees, or only family member employees. The employer-owner is then free to “max out” their contribution without an obligation to make a proportionately large contribution for other employees.
SEP Contribution Examples
EXAMPLE 1: Jessica James is a highly successful dealer in high-end rare books, original manuscripts, and other antiquities, and has no common-law employees. As a sole proprietor, her compensation for 2024—when adjusted for self-employment tax, and for her intended SEP contribution—was $375,000. She hoped to make the maximum allowable SEP contribution.
She faced several statutory limitations, however. Because the 2024 compensation cap (the maximum compensation amount that can be taken into account when making contribution allocations) was $345,000, under this first limitation her maximum 25 percent SEP contribution would have been $86,250. However, the 2024 annual additions limit—the maximum contribution that can be received under all plans of the same employer—was $69,000, so that was the maximum she could ultimately receive under her SEP plan, even though less than her actual compensation might suggest.
EXAMPLE 2: Due to a number of factors, Jessica’s 2025 sole proprietor income—again, as adjusted for self-employment tax, and for her intended SEP contribution—is $200,000. This amount is well below the $350,000 2025 compensation cap, so that statutory limitation does not come into play. Her $200,000 compensation times 25 percent is $50,000, which is well below the $70,000 2025 annual additions limit.
If Jessica had a SAR-SEP in addition to her standard SEP—one established before 1997—she could have made up the $20,000 gap between her $50,000 employer contribution and the $70,000 2025 annual additions limit by making salary deferral contributions. This is so because the 2025 salary deferral limit is $23,500 for those under age 50, and higher for those 50 and older.
NOTE: Although a SEP plan could define compensation for employer contribution purposes as total compensation reduced by salary deferrals—if so defined in the plan’s document—it would not be in a sole proprietor’s best interest to do so, as it could potentially reduce the maximum employer contribution.
What SEP Document?
As it does for IRAs, The IRS issues model documents for both standard SEP and SAR-SEP plan arrangements. Many retirement plan forms providers base their documents on the IRS model, with few or no substantive changes, as they are permitted to do. In addition, any employer may use the IRS model documents as-is, straight from the IRS website.
But if an employer sponsors another retirement plan in addition to a SEP plan, or has operated a defined benefit plan in the past, the SEP document must be a prototype that has been submitted to, and approved by, the IRS. It is believed that this requirement has been in place to coordinate benefits between the SEP and a second retirement plan.
The SEP plan may not be the ideal choice for every employer. But for those whose needs are met by this—one the most simple and straightforward of retirement plans—it can be the perfect fit.
