Key Points
Overview
In 1978, Congress provided employers with an easier way of offering retirement benefits for themselves and their employees through Simplified Employee Pensions (SEPs). A SEP is simply an individual retirement account or annuity (IRA) that may receive a higher level of employer contributions than a regular IRA. Any employer, regardless of size, may establish a SEP.
Because the employer is not required to establish a trust — as with other qualified retirement plans — the SEP eliminates many of the fiduciary and administrative responsibilities associated with traditional pension and profit-sharing plans. The IRS has developed a simple one-page form (Form 5305-SEP) to establish a SEP plan, making it the simplest, most efficient, and least expensive way for a small business to provide retirement benefits for its employees.
As with all qualified plans, SEP contributions are not taxable when contributed and are deductible by the employer in the tax year they are made. Earnings in the accounts grow tax-deferred. Participants are taxed on any withdrawals in the year they are taken.
How SEPs Work
Under a SEP, the employer contributes directly into each eligible employee’s individual IRA account. The employee owns and controls the account — there is no separate plan trust. Contributions must be allocated to all eligible employees using a uniform percentage of compensation.
Each eligible employee must have an IRA (or IRA annuity) to receive SEP contributions. If an employee does not already have an IRA, they must establish one. The employer may contribute to an existing IRA or require employees to open new accounts specifically designated as SEP-IRAs.
Because the funding vehicle is an IRA, SEP participants enjoy all the normal IRA features — investment flexibility, portability, and familiar distribution rules. SEP contributions are held separately from any regular IRA contributions the employee makes.
All SEP contributions are immediately and 100% vested from the moment they are deposited. Unlike qualified plans that may impose cliff or graded vesting schedules, SEP participants own their entire account balance at all times. This is a significant advantage for employees but means the employer forfeits forfeitures as a cost-reduction tool.
The IRS provides Form 5305-SEP as a standardized, IRS-approved plan document. Key features of Form 5305-SEP:
- It is a simple one-page document — no IRS approval is required.
- The employer completes the form and provides a copy to each eligible employee.
- The employer does not file the form with the IRS.
- The plan is established on the date the employer signs the form.
- Employers who want non-standard provisions (such as integration with Social Security) must use a prototype or individually designed SEP plan document instead.
A SEP may also be established retroactively — up to the employer’s tax filing deadline (including extensions) for the prior tax year. This is another administrative advantage over qualified plans, which generally must be established by December 31 of the plan year.
| Item | 2026 Amount |
|---|---|
| Maximum contribution (% of compensation) | 25% of compensation |
| Maximum annual contribution (dollar cap) | $72,000 |
| Compensation cap for contribution calculations | $360,000 |
| Minimum compensation to be eligible (typical) | $750 (inflation-adjusted) |
The employer’s deduction for SEP contributions is limited to 25% of total eligible employee compensation (not to exceed the compensation cap per individual). For self-employed individuals, the effective rate is approximately 20% of net self-employment income after the deductible portion of self-employment tax is taken into account.
SEP contributions are separate from and in addition to any regular (traditional or Roth) IRA contributions an employee may make personally. An employee who is covered by a SEP may also make personal IRA contributions up to the annual IRA limit ($7,500 in 2026, or $8,600 if age 50+), subject to the usual income and deductibility rules.
SEPs vs. Qualified Plans
SEPs offer significant administrative advantages over traditional qualified plans such as defined benefit plans or 401(k)s:
| Feature | SEP | Qualified Plan (401k/Pension) |
|---|---|---|
| Trust required | No — uses employee IRAs | Yes |
| IRS approval required | No (Form 5305-SEP) | Generally required |
| Annual Form 5500 filing | Not required | Required |
| Vesting schedule | Immediate 100% | May be deferred (cliff or graded) |
| Plan can be established after year-end | Yes — up to tax filing deadline | Generally no — must be by Dec 31 |
| Employer may skip contributions | Yes — discretionary each year | Depends on plan type |
| Nondiscrimination testing | Simplified (uniform % rule) | Complex ADP/ACP and coverage tests |
| Employee elective deferrals | No (SARSEP only, pre-1997) | Yes (401k) |
| 2026 max contribution | $72,000 | $72,000 (DC plans) |
The primary disadvantage of a SEP compared to a 401(k) is that employees cannot make elective deferrals (other than in grandfathered SARSEPs). All contributions come from the employer. This means the employer bears the full cost of funding the plan.
SARSEPs
A Salary Reduction SEP (SARSEP) is a special type of SEP that allows employees to make elective salary deferrals into their SEP-IRA accounts, similar in concept to a 401(k) plan. The funding mechanism remains the IRA, but employees may choose to reduce their salary and have the difference contributed to their SEP-IRA.
To maintain a SARSEP, the employer must have had 25 or fewer eligible employees at any time during the preceding calendar year, and at least 50% of eligible employees must elect to participate.
With the creation of SIMPLE plans in 1996, Congress prohibited the establishment of new SARSEPs after December 31, 1996. However, employers who established a SARSEP before 1997 may continue to maintain it and make contributions — both existing and new employees of those employers may continue to participate.
The rationale was that SIMPLE plans provide a more straightforward alternative for small employers who want to offer employee elective deferrals. SARSEPs will be discussed further in ch46.