The SEP IRA (Section 408(k))

How it works

A SEP, short for Simplified Employee Pension, is not a special kind of account. It is a funding mechanism under IRC sec. 408(k)(1): the employer contributes to a traditional IRA set up for each eligible employee, including the owner. The account itself is an ordinary IRA. What makes it a SEP is the rule governing who put the money in and how much.

Every dollar in a SEP is employer money. The business deducts the contribution, the employee or owner excludes it from income on a traditional SEP, and it grows tax-deferred until withdrawal. SECURE 2.0 Section 601 added a Roth option here as well, and a contribution made to a Roth SEP IRA is included in the employee's income rather than excluded from it. There is no employee salary-deferral feature built into a SEP. That option only ever existed under grandfathered SARSEPs, which closed to new plans after 1996. A modern SEP is employer-funded or it is nothing.

I have a separate article that walks through the practical choice between a SEP and a Solo 401(k), call by call, for someone still deciding between the two: Solo 401(k) vs SEP IRA. This page stays on the SEP by itself: what it actually is, who it fits, and where it fails.

The contribution ceiling is the lesser of two numbers: 25% of compensation, or the dollar cap fixed each year under IRC sec. 415(c)(1)(A). That 25% figure is written for someone paid W-2 wages. A sole proprietor or single-member LLC owner has no W-2, so the base is net self-employment earnings after the deduction for one-half of self-employment tax under IRC sec. 164(f) and IRC sec. 1402(a)(12), and the percentage that lands on that smaller base works out to an effective 20%, using the reduced-rate formula the IRS publishes for the self-employed: the plan rate divided by one plus the plan rate, or 25% divided by 1.25. Compensation above the IRC sec. 401(a)(17) cap is ignored entirely once that percentage is applied.

Where the deduction lands depends on the entity. A corporation deducts the contribution on its own return. A sole proprietor takes it above the line, on Schedule 1, not on Schedule C, because it is the owner's own retirement contribution rather than a cost of running the business.

The Florida angle

This is a pure federal point for a Florida sole proprietor or a single-member LLC, where the deduction flows straight to the owner's individual return. Florida has no individual income tax and does not tax pass-through income at the personal level, so for that owner there is no state-level layer for this deduction to interact with at all. Filing stays light too: Form 5305-SEP is retained in the owner's own records, never filed with the IRS or with the state.

Who this applies to

A SEP can be adopted by any business form: a sole proprietor or single-member LLC on Schedule C, a partnership, an S corporation, or a C corporation. There is no income floor or ceiling to establish one, but funding it takes positive net self-employment earnings, or W-2 compensation from your own corporation if the business is an S corp or a C corp. An owner with no employees at all is the ideal case, because the one condition that complicates everything else, covering employees, never comes up.

Where a business does have workers, the question is who among them counts. Under IRC sec. 408(k)(2), an eligible employee is someone who has reached age 21, performed service in at least three of the immediately preceding five years, and received minimum compensation for the year, a figure indexed from a $450 statutory base to $750 for 2025 and $800 for 2026. A plan may set less restrictive terms than these three, but never more restrictive ones.

• Who can be left out. Employees whose retirement benefits were collectively bargained, and nonresident aliens with no U.S.-source compensation, may be excluded from coverage.
• Who this is easiest for. An owner with no eligible employees at all, where the proportional-coverage question that drives most of this page's failure modes simply does not arise.

For an S corporation, the SEP is funded on W-2 wages rather than net self-employment earnings, so how much reasonable compensation the owner draws directly sizes the SEP ceiling. Whether an S-corp election makes sense in the first place is a separate question, and one I cover in my Florida S-corp guide.

What it requires

Several conditions have to hold, and they attach to different things: some to the plan, some to the people it covers, some to the calendar.

• Proportional coverage. If the business has any eligible employees, IRC sec. 408(k)(3)(C) requires contributions to bear a uniform relationship to compensation for every one of them, the same percentage the owner receives. Favoring highly compensated employees is not allowed. This is the dealbreaker once a business has staff.
• The dollar and compensation caps. The 25%-or-20% calculation is capped at the sec. 415(c) dollar figure regardless of income, and compensation above the sec. 401(a)(17) figure is disregarded when the percentage is computed.
• Timing. A SEP can be established and funded as late as the due date of the business return, including extensions. A calendar-year Schedule C filer who extends has until October 15 of the following year to do both, for the prior year. A Solo 401(k) has the same document deadline, not an earlier one: Section 401(b)(2), added by the SECURE Act, lets an employer adopt the plan as late as the extended due date of the return and treat it as adopted on the last day of that year. What generally cannot be done after year end is the employee elective deferral, and even that has an opening, since SECURE 2.0 Section 317 allows it for a sole proprietor's first plan year up to the unextended due date.
• No other qualified plan, if using the model form. The IRS model Form 5305-SEP cannot be relied on if the employer maintains any other qualified plan. A plan counts as maintained even in a year it received no contributions, with one exception: another SEP. A business already running a 401(k) can still have a SEP, but needs a prototype or an individually designed plan document rather than the model form.

What you need to document

None of this is complicated to run, but it has to be provable after the fact, especially because the deadline flexibility that makes a SEP attractive also means the file is often assembled well after the year it covers.

The signed plan agreement

Form 5305-SEP, or a prototype or individually designed plan if another qualified plan is already in place. It stays in the business's own records and is given to every eligible employee with instructions. It is never filed with the IRS.

The contribution worksheet

A record tracing net profit to the one-half self-employment-tax deduction, to the reduced 20% rate, to the dollar and compensation caps, so the number that was actually contributed can be reconstructed from the return rather than taken on faith.

Proof of timely deposit

Bank or custodian records dated on or before the extended due date. The deadline is the point of the whole arrangement, so it has to be demonstrable, not just remembered.

The employee notice

Where there are eligible employees, a copy of the signed plan and its instructions actually given to each one. Skipping this is an operational failure, not a formality.

Where it goes wrong

A SEP is a mainstream, non-aggressive deduction. It is not a listed or reportable transaction. What goes wrong here is mechanical, not a question of characterization.

The proportional coverage trap

This is the single biggest reason a practitioner will steer a business with employees toward a 401(k) instead of a SEP. It usually starts innocently: a business adopts a SEP while it is just the owner, funds it for a few years, then hires someone who crosses the age-21, three-of-five-years, minimum-compensation line into eligibility. If the owner keeps funding only their own account at the old percentage, the plan is out of compliance the moment that employee becomes eligible, whether or not anyone notices right away.

The recurring mechanical errors

• Wrong base, wrong rate. Applying the full 25% to net profit, instead of the effective 20% to net self-employment earnings after the half-SE-tax adjustment, overstates the contribution. The correction for an excess contribution is a 6% excise tax under IRC sec. 4973 until it is fixed.
• Comp-cap omission. Forgetting to cap compensation at the sec. 401(a)(17) figure before computing the 25%.
• Using the model form incorrectly. Relying on Form 5305-SEP while another qualified plan is already maintained voids reliance on the model form; a prototype plan is needed instead.
• Skipping the employee notice. Treating the notice to eligible employees as optional once the money is deposited.
• Promising a feature that does not exist. A SEP has no catch-up contribution, no loan provision, and no salary deferral of any kind, because every dollar in it is an employer contribution. An owner who wants any of those needs a different plan, not a SEP funded more creatively.

A situation where this comes up

The version I see most often is the rescue case. It is well into the following year, usually after an extension has already been filed, and a solo Schedule C filer realizes the year that just closed was a genuinely profitable one with no retirement plan in place to shelter any of it. A SEP is often the rescue at that point, because it can be established and funded as late as the extended due date of the return. A Solo 401(k) can have its plan document adopted on that same schedule under Section 401(b)(2); what it generally cannot do after year end is the employee elective deferral, outside SECURE 2.0 Section 317's first-year opening for a sole proprietor.

The other version is the true solo operator who wants as little administration as possible: no plan document deadline to track during the year, no loans or deferral elections to administer, just a percentage-of-earnings contribution decided at filing time. For someone in that position, a SEP does everything it needs to do without asking much of them.

The version that worries me is the business that adopted a SEP back when it was one person, and has since hired one or two employees without revisiting the plan. Nothing about a SEP forces that conversation. The percentage the owner has been funding for years is still being funded, an eligible employee has quietly crossed into coverage, and the uniform-contribution requirement is being violated every year it continues, invisibly, until someone finally checks.