So, what is it exactly?
A SEP — which stands for simplified employee pension plan— is a retirement account. It works kind of like a Traditional IRA or a Roth IRA with a few key differences that make the SEP an especially good retirement account for small businesses and the self-employed (in fact, they’re only available to small businesses and the self-employed).
First, some similarities. Like a traditional IRA, your contributions to a SEP are what’s called pre-tax. Which means you don’t pay income tax on the money you contribute. The deduction math is pretty complicated, so check out the IRS’s handy table if you want to know how it works. But the main difference is that a SEP IRA is supposed to replace a 401(k) plan for people who don’t have one. Which means you can contribute a whole lot more to it. A traditional IRA has an annual maximum contribution of $5,500; a Roth IRA also has a maximum contribution $5,500 (though there’s a sliding scale); but the SEP maxes out at $54,000 per year, or 25% of your income, whichever is lower. If you work for a small business, your employer can also make contributions on your behalf – up to 25% of your compensation.
Later, when you start to withdraw money from the account, it’s taxed like regular income — as long as you make the withdrawals after the age of 59 ½. Withdrawals made before then will usually incur penalties.
What are the pros?
The main benefit of this type of account is that it allows freelancers and small business employees to save like they have a 401(k). You can simply save a whole lot more with a SEP than any other individual retirement account. Plus, for those in the gig economy who have elastic cash flow and variable income, the fact that you have until tax day to contribute can be helpful.
Is there anything to be careful about?
Early withdrawals. If you find yourself in a tight financial situation need to take money out before you hit that 59½ milestone, you may have to pay a 10% income tax penalty (i.e., you’ll pay income tax on the withdrawal at the normal rate, plus another 10%). That is, unless you qualify for an exception.
And when you’re doing your retirement math, don’t forget that you will eventually have to pay income tax on your withdrawals in the year you make them.