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Small businesses and self-employed individuals often look for ways to save for retirement while reducing taxes. The U.S. tax system allows business owners to create retirement plans not only for themselves but also for their employees.
The most common retirement plans for small businesses include:
- Simplified Employee Pension (SEP)
- SIMPLE IRA Plan
- Qualified Plans such as 401(k)
Each plan has its own rules regarding contributions, eligibility, tax deductions, distributions, and reporting requirements. This guide explains these plans in clear and simple language so beginners and tax learners can understand how they work.
Simplified Employee Pension (SEP)
A SEP plan is one of the easiest retirement plans for small businesses and self-employed individuals.
It allows an employer to contribute to retirement accounts for both themselves and their employees without dealing with the complex rules required for larger qualified plans.
In a SEP plan, the employer contributes directly into a SEP-IRA, which is a type of traditional individual retirement account established for each employee.
One of the biggest advantages of a SEP plan is flexibility. The employer can establish the plan as late as the due date of the business tax return, including extensions.
This means a business owner can decide to set up the plan after the tax year has ended and still make contributions for that year.
The employer must contribute to the SEP plan by the due date of the tax return including extensions, and these contributions are reported on Form 5498.
Although the employer contributes to the account, the SEP-IRA is owned and controlled by the employee.
Self-Employed Individuals and SEP Plans
A self-employed person is treated as both the employer and the employee for SEP purposes.
This means a freelancer or sole proprietor can establish a SEP-IRA even if they have no employees.
However, the person must have net earnings from self-employment. If the business has a loss, that loss cannot reduce wages from other employment when determining compensation.
The deduction for SEP contributions is reported on Schedule 1 of Form 1040.
Who Qualifies as an Employee in a SEP Plan
Not every worker automatically qualifies for a SEP plan. An employee must meet the following conditions:
The employee must be at least 21 years old.
The employee must have worked for the employer during at least three of the previous five years.
The employee must receive at least $750 in compensation during the tax year (updated IRS threshold).
Employees covered by a collective bargaining agreement or certain nonresident aliens may be excluded from the plan.
SEP Contribution Limits (Updated)
Employer contributions to a SEP plan are limited.
The contribution cannot exceed the lesser of 25% of employee compensation or $70,000 (2025 limit).
When calculating compensation for SEP purposes, only the first $350,000 of compensation can be considered.
Unlike traditional IRA contributions, SEP contributions are excluded from the employee’s income, meaning the employee does not report the contribution as taxable income.
If an employer contributes more than the allowable amount, a 10% excise tax may apply to the excess contribution.
SIMPLE IRA Plans
A SIMPLE plan (Savings Incentive Match Plan for Employees) is another retirement plan designed for small businesses.
Employers with 100 or fewer employees who earned at least $5,000 in the previous year can establish a SIMPLE plan.
However, the employer cannot maintain another qualified retirement plan at the same time.
A SIMPLE plan must generally be available to employees who:
- Earned at least $5,000 in compensation in any two previous years
- Are expected to earn at least $5,000 in the current year
Self-employed individuals may also participate in a SIMPLE plan.
Employee Contributions to SIMPLE Plans (Updated)
Employees can make salary reduction contributions to the plan.
For 2025, the contribution limit is:
- $16,500 standard contribution
- $20,000 if age 50 or older (catch-up contribution)
Because these contributions are made from salary, they reduce the employee’s taxable income.
Employer Contributions in SIMPLE Plans
Employers must contribute to SIMPLE plans using one of two methods.
The most common method is a matching contribution.
The employer matches employee contributions dollar for dollar up to 3% of the employee’s compensation.
For example, if an employee earns $95,000 and contributes $8,000 to the plan, the employer contributes 3% of compensation, which equals $2,850.
Alternatively, the employer can make a 2% nonelective contribution for each eligible employee earning at least $5,000.
Only the first $350,000 of compensation is considered when calculating this contribution.
Employer contributions to SIMPLE plans are 100% vested immediately, meaning the employee owns the contribution right away.
Withdrawals and Penalties in SIMPLE Plans
Withdrawals from a SIMPLE IRA are generally taxed the same way as withdrawals from a traditional IRA.
If funds are withdrawn before age 59½, a 10% penalty usually applies.
However, if the withdrawal occurs within the first two years of participation, the penalty increases to 25%.
Qualified Retirement Plans
Qualified retirement plans include plans such as 401(k) plans, profit-sharing plans, and defined benefit pension plans.
These plans must follow strict rules established by tax law.
Qualified plans can be established by corporations, partnerships, or sole proprietors.
A self-employed individual is considered both an employer and an employee for purposes of a qualified plan.
To establish a qualified plan, an employer must either adopt an IRS-approved prototype plan or create a written plan that meets Internal Revenue Code requirements.
Types of Qualified Plans
Qualified plans fall into two main categories.
The first category is the defined contribution plan.
In this type of plan, each participant has an individual account. Benefits depend on contributions made and the investment performance of the account.
Examples include profit-sharing plans and 401(k) plans.
The second category is the defined benefit plan.
This type of plan promises a specific retirement benefit based on factors such as salary and years of service.
PDF Notes
Contribution Limits for Qualified Plans (Updated)
For defined contribution plans (2025), total contributions cannot exceed:
The lesser of:
- 100% of compensation, or
- $70,000
For defined benefit plans, the maximum annual benefit cannot exceed:
The lesser of:
- 100% of the participant’s highest three-year average compensation, or
- $280,000 (2025 limit)
401(k) Plans and Elective Deferrals (Updated)
A 401(k) plan allows employees to contribute part of their salary to the retirement plan before taxes.
These contributions are known as elective deferrals.
For 2025, the maximum elective deferral is:
- $23,500
- $31,000 if age 50 or older (catch-up contribution)
The money remains tax-deferred until it is withdrawn during retirement.
Retirement Plan Rollovers
A distribution from a retirement plan can often be rolled over into another retirement account to avoid immediate taxation.
If a distribution is paid directly to the taxpayer, the plan administrator must usually withhold 20% for federal income tax.
However, if the distribution is transferred directly from one plan to another in a direct rollover, withholding does not apply.
Required Minimum Distributions (RMDs) – Updated Rule
Retirement accounts cannot remain untaxed forever.
Participants must begin taking required minimum distributions (RMDs) by April 1 of the year following the year they reach age 73 or retire, whichever occurs later.
After the first required distribution, RMDs must be taken by December 31 each year.
Failure to withdraw the required amount can result in a 25% penalty tax (reduced from the old 50% rule).
Borrowing from a Retirement Plan
Some qualified plans allow participants to borrow from their retirement accounts.
Loans generally cannot exceed the lesser of $50,000 or 50% of the participant’s vested account balance.
Loans must typically be repaid within five years, unless the funds are used to purchase a primary residence.
Repayments must be made in regular installments, usually at least quarterly.
Early Distribution Penalty
If a participant withdraws money from a retirement plan before reaching age 59½, the distribution may be subject to a 10% additional tax.
However, several exceptions exist.
Examples include:
- Disability
- Death
- Certain medical expenses
- Qualified domestic relations orders
- Certain education or first-home expenses for IRAs
Prohibited Transactions
Certain transactions involving retirement plans are prohibited.
These transactions generally involve interactions between the plan and a disqualified person.
A prohibited transaction can result in a 15% excise tax, and if it is not corrected, an additional 100% tax may apply.
Examples include:
- Using plan assets for personal benefit
- Lending money between the plan and a disqualified person
- Selling property between the plan and such individuals
Retirement Plan Reporting Requirements
Retirement plans must report information to government agencies each year.
Annual plan reports must generally be filed by the last day of the seventh month after the plan year ends.
Several forms may be used depending on the type of plan.
Form 5500-SF is used for small plans with fewer than 100 participants.
Form 5500-EZ is used for one-participant plans owned by a business owner and spouse.
Form 5500 is used for larger plans that do not qualify for the simplified forms.
When retirement plan distributions occur, they are reported to the taxpayer and the IRS using Form 1099-R.
All Form 5500 series filings must be submitted electronically through the government’s EFAST2 system.
Retirement plans provide significant tax advantages for small businesses and self-employed individuals. Plans such as SEP IRAs, SIMPLE IRAs, and 401(k) plans allow business owners to save for retirement while also providing benefits to employees.
Understanding the differences between these plans, their updated contribution limits, and reporting requirements helps ensure compliance with tax laws while maximizing retirement savings opportunities.
For small business owners, choosing the right retirement plan can play a crucial role in tax planning, financial growth, and employee retention.
If you are also interested in understanding Exempt Organizations under IRS 501(c) and their tax rules, forms, and requirements, you can read our complete guide here
FAQs – Retirement Plans for Small Businesses (SEP, SIMPLE, and 401(k))
1. What is a SEP IRA and who can open one?
A SEP IRA (Simplified Employee Pension) is a retirement plan that allows employers, including self-employed individuals, to contribute to their employees’ retirement accounts. Self-employed individuals can also open a SEP IRA for themselves, even if they have no employees.
2. What are the contribution limits for a SEP IRA?
For 2025, an employer can contribute the lesser of 25% of compensation or $70,000 per employee. Only the first $350,000 of compensation is considered when calculating contributions.
3. Who qualifies as an employee in a SEP plan?
Employees must meet these requirements:
- At least 21 years old
- Worked for the employer 3 of the past 5 years
- Earned at least $750 during the tax year
Certain nonresident aliens and employees under collective bargaining agreements may be excluded.
4. What is a SIMPLE IRA and who is eligible?
A SIMPLE IRA is designed for small businesses with 100 or fewer employees. Eligible employees are those who earned at least $5,000 in any two prior years and are expected to earn $5,000 in the current year.
5. What are the contribution limits for a SIMPLE IRA?
For 2025:
- Employee contribution: $16,500
- Catch-up contribution (age 50+): $20,000
- Employer contribution: 3% matching or 2% nonelective of compensation, up to $350,000 of employee compensation.
6. Can I contribute to a 401(k) as a self-employed individual?
Yes. Self-employed individuals can establish a solo 401(k) and contribute as both employer and employee, following the annual limits.
7. What are the 401(k) contribution limits for 2025?
- Employee elective deferral: $23,500
- Catch-up contribution (age 50+): $31,000
- Total contribution including employer portion: up to $70,000 (lesser of 100% of compensation or limit).
8. What are required minimum distributions (RMDs)?
RMDs are minimum withdrawals required from retirement accounts. Participants must start by April 1 of the year after turning 73 or retiring, whichever is later. Failure to take RMDs may result in a 25% penalty.
9. Can I withdraw money early from these retirement plans?
Yes, but withdrawals before age 59½ may incur a 10% penalty, except for exceptions like disability, death, medical expenses, or first-home/education expenses for IRAs. SIMPLE IRA withdrawals within the first 2 years have a 25% penalty.
10. Are there reporting requirements for retirement plans?
Yes. Plans must file annual reports using Form 5500-SF, 5500-EZ, or 5500, depending on plan size. Distributions are reported using Form 1099-R, and filings must be submitted electronically via the EFAST2 system.
11. Can I take a loan from my retirement plan?
Some plans allow loans up to the lesser of $50,000 or 50% of your vested balance, typically repayable within 5 years unless used to buy a primary residence.
12. What happens if I exceed contribution limits?
Excess contributions may trigger a 10% excise tax for SEP IRAs and corrective actions for other plans. Always monitor contributions carefully.
