Learn how a SEP IRA works, who can establish one, how self-employed contribution limits are calculated, and what California business owners should know.
A SEP IRA is an individual retirement account that receives employer contributions under a Simplified Employee Pension plan. A sole proprietor, partnership, corporation, nonprofit, or other employer can establish a SEP, including a self-employed person with no employees. Traditional SEP contributions are generally deductible to the employer and tax-deferred to the participant until distribution.
A SEP is simple to administer, but it is not merely a larger personal IRA. The employer establishes the plan, applies its eligibility and allocation terms, and generally contributes the same percentage of compensation for every eligible participant.
Any size business can establish a SEP. The employer can use IRS Form 5305-SEP when eligible, adopt an approved financial-institution document, or use an individually designed plan. Form 5305-SEP cannot be used in certain circumstances, including when the employer maintains another qualified plan other than another SEP.
The plan document defines eligibility within legal limits. An employer generally cannot exclude an employee who is at least age 21, performed service in at least three of the preceding five years, and received at least the indexed minimum compensation for the current year. For 2026, that compensation threshold is $800. A plan may use less restrictive requirements.
Certain union employees, nonresident aliens without U.S.-source earned income, and employees covered by specified acquisition transition rules can be excluded when requirements are met. Part-time, seasonal, or short-hours employees cannot be excluded merely because the employer did not view them as full time.
For 2026, an employer's contribution to an employee's SEP IRA cannot exceed the lesser of:
The maximum compensation considered for 2026 is $360,000. A regular SEP does not permit employee salary-deferral contributions or age-50 catch-up contributions. Grandfathered salary-reduction SEPs, called SARSEPs, follow separate rules.
An employer can generally decide each year whether to contribute, including a zero contribution. When it contributes under the usual pro-rata formula, it must use the same percentage of eligible compensation for all covered employees. Contributions are immediately 100% vested.
A self-employed owner cannot simply multiply Schedule C profit by 25%. Net earnings must first be reduced by the deductible portion of self-employment tax, and the contribution itself affects the compensation base. A stated 25% plan rate generally becomes a 20% reduced contribution rate for the owner before applying the annual limit.
Example: Jordan has $100,000 of net profit before the SEP deduction. If the deductible portion of self-employment tax is $7,065, adjusted net earnings are $92,935. At the reduced 20% rate, the tentative SEP contribution is $18,587:
$100,000 − $7,065 = $92,935
$92,935 × 20% = $18,587
Actual self-employment tax, other plans, controlled businesses, partnership income, and employee contributions can change the result. S-corporation pass-through profit is not self-employment compensation for this purpose; SEP contributions for an S-corporation owner are generally based on eligible W-2 compensation.
A SEP generally can be established by the employer's tax-return due date, including extensions, for the year to which the contribution relates. Contributions generally must also be made by that due date, including extensions, to be deducted for that year. The exact deadline depends on the entity and its return.
The employer should execute the plan document, ensure every eligible employee has a qualifying SEP IRA, provide required information, calculate contributions consistently, make deposits timely, and retain proof of the tax year designated. Form 5305-SEP is kept with plan records rather than filed annually with the IRS.
For a sole proprietor or self-employed partner, the deductible contribution for the owner generally appears as a self-employed SEP, SIMPLE, or qualified-plan deduction on Schedule 1 of Form 1040 rather than as a Schedule C expense. Contributions for common-law employees are generally deducted on the business return.
The financial institution generally reports contributions on Form 5498. Traditional SEP contributions are generally not included in an employee's Form W-2. Distributions are commonly reported on Form 1099-R and follow traditional-IRA rules, including ordinary-income treatment, possible early-distribution tax, and required minimum distributions.
SECURE 2.0 permits employers to offer Roth treatment for SEP contributions, but implementation depends on plan and custodian availability and changes the current-income treatment. Confirm the document, election, reporting, and current guidance before assuming a contribution is Roth.
A SEP is funded by employer contributions and is often flexible for a business with variable profit. A Solo 401(k) can combine employee deferrals with employer contributions for an owner-only business and may allow catch-up contributions, potentially creating a different maximum at moderate income. A SIMPLE IRA requires specified employer funding and allows employee salary reductions, generally with lower limits and broader ongoing obligations.
The best plan depends on compensation, employees, cash flow, desired contribution, administrative tolerance, other controlled businesses, and timing. A SEP can become expensive when the owner wants a high percentage and has eligible employees because the same percentage generally applies to them.
California's SEP deduction is generally the same as the federal deduction. Differences can arise when California and federal self-employment income differ. Part-year residents and nonresidents generally limit the California deduction using California compensation or California-source self-employment income under Schedule CA (540NR) instructions.
California generally treats traditional SEP distributions like IRA distributions. Historical federal-versus-California basis differences can affect taxable amounts, so preserve prior Schedule CA and FTB Publication 1005 records.
Heath Income Tax can help a business calculate SEP contribution limits, coordinate payroll and entity compensation, and report the federal and California deductions.
Can I open a SEP IRA after year-end?
Often yes. A SEP can generally be established and funded by the employer return's due date, including a valid extension, for the prior tax year. Confirm the entity deadline and custodian processing time.
Can a SEP contribution vary from year to year?
Yes. A regular SEP generally permits discretionary employer contributions, including no contribution, but the allocation formula must be applied consistently to eligible employees for a contribution year.
Can I contribute to both a SEP IRA and a personal IRA?
Potentially. SEP employer contributions do not use the regular personal IRA contribution limit, but SEP participation can affect deductibility of a separate traditional IRA contribution, and overall plan limits still require review.
The definitions and examples on this page are for informational purposes only and do not constitute tax advice. Tax laws change frequently and individual circumstances vary. Consult a qualified tax professional before making decisions based on this content.
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