A SEP IRA (Simplified Employee Pension) is one of the simplest retirement plans a small business can offer, and it’s especially popular with S-corp owners because it can allow sizable, tax-advantaged retirement contributions with relatively light administration.
The “simple” part can be misleading, though: SEP contributions must follow very specific rules on eligibility, compensation, timing, and equal treatment of employees. When the setup and payroll pieces are handled correctly, a SEP can be a clean way to build retirement savings while keeping your business compliant and your deductions well-documented.
Understanding SEP IRAs for S-Corp Owners
What a SEP IRA Is and Its Core Purpose
A SEP is an employer-sponsored retirement arrangement where the business contributes to traditional IRAs (called SEP-IRAs) established for eligible employees, including the owner if the owner is an employee. Only the employer contributes—employees do not make salary deferrals like they would in a 401(k).
A big reason owners like SEPs is flexibility: contributions can be changed year to year, including contributing nothing in a lean year. But when you do contribute, the plan rules must be followed consistently, and the contribution rate must be applied uniformly to eligible employees.
Who Qualifies to Participate in an S-Corp SEP Plan
Eligibility is one of the places S-corps get tripped up. A SEP must generally include employees who meet the plan’s requirements, and those requirements cannot be more restrictive than the IRS maximums.
The standard “maximum restrictions” are: the employee is at least 21, worked for the employer in at least 3 of the last 5 years, and received at least the minimum required compensation (the IRS lists $750 for recent years, and it can be adjusted periodically). Employers can choose less restrictive rules (for example, letting younger or newer employees in), but not more restrictive ones.
How S-Corp Compensation Affects SEP Contributions
The Importance of W-2 Wages for SEP Calculations
For an S-corp owner who works in the business, SEP contributions are tied to compensation—practically, that means your W-2 wages as a common-law employee. This is why payroll is not just a formality for S-corp owners: the salary you run through payroll often drives how much you can contribute to a SEP. Setting wages too low can dramatically shrink the maximum SEP contribution you’re allowed to make for yourself, even if the business is profitable.
Why Distributions Cannot Be Used for SEP Contributions
This is the non-negotiable rule that causes the most confusion: S-corp distributions are not compensation for retirement plan purposes. In other words, you can’t use distributions to “create” SEP contribution room.
The IRS is explicit that distributions you receive as an S corporation shareholder do not constitute earned income for retirement plan purposes, so they aren’t the basis for retirement plan contributions. If you want a higher SEP contribution, the lever you’re usually pulling is W-2 wages (while still staying within “reasonable compensation” standards).
What Counts as “Compensation” Under IRS Rules
A SEP plan document must define compensation, and you must operate the plan using that definition. In general, compensation includes pay received for personal services for the year, but the exact treatment can depend on the plan document you adopted.
The key is consistency: once you adopt a definition of compensation, you follow it for all participants, not just the owner. Also note that SEP plans have an annual compensation cap for calculation purposes (for example, the IRS lists a $350,000 “SEP maximum compensation” figure for 2025).
Calculating SEP IRA Contributions the Right Way
Understanding the 25% Employer Contribution Formula
At a high level, SEP contributions are limited to the lesser of (1) 25% of compensation or (2) the annual maximum contribution limit. The IRS also makes clear that elective salary deferrals and catch-up contributions are not permitted in a SEP IRA (that’s a 401(k)-style feature, not a SEP feature). So the math is usually straightforward: choose a percentage (0% to 25%), then apply that same percentage to each eligible employee’s compensation, subject to the annual caps.
How the Annual IRS Limit Applies to S-Corp Owners
SEP plans have annual limits that change over time. For 2025, the IRS lists a SEP maximum contribution of $70,000 and a maximum compensation limit of $350,000 for SEP calculations. That means even if someone earns more than the compensation cap, the plan can only “count” compensation up to that cap when determining the employer contribution amount for that person. These limits are important for owners because once your W-2 wages are high enough, you hit the point where a higher salary no longer increases your allowable SEP contribution.
Sample Calculations at Different Owner Salary Levels
Here are simple examples using the standard SEP approach (25% maximum rate) and the 2025 IRS dollar limits:
- If your W-2 wages are $80,000, then 25% would be $20,000. That’s under the annual SEP maximum contribution, so $20,000 is potentially allowable.
- If your W-2 wages are $200,000, then 25% would be $50,000. Still under the annual maximum, so $50,000 is potentially allowable.
- If your W-2 wages are $320,000, then 25% would be $80,000, but you can’t exceed the annual SEP maximum contribution for 2025, which is $70,000. So the limit becomes $70,000, not $80,000.
And if your wages go above the compensation cap, the extra wages don’t increase the planned calculation base anyway.
When to Adjust Salary to Optimize SEP Contribution Potential
Many S-corp owners discover a practical truth: if you want higher SEP contributions for yourself, you often need enough W-2 wages to support them. But “optimize” does not mean “pick any number you want.” S-corp shareholder-employees are expected to take reasonable compensation for the work they perform, and wages should reflect role, duties, hours, and market norms.
A smart approach is to coordinate payroll, SEP planning, and overall tax strategy together—this is where solid tax and accounting services can pay for themselves by helping you avoid a salary that is either too low to support your retirement goal or unnecessarily high for your situation.
Setting Up and Administering Your SEP IRA Through the S-Corp
Required IRS Forms and Initial Setup Process
A SEP must be established with a written agreement that includes participation requirements and a definite allocation formula. The IRS provides a model document, Form 5305-SEP, and importantly, you do not file it with the IRS.
However, Form 5305-SEP has limitations: for example, if you maintain another qualified plan (other than another SEP), you generally can’t use the model form and must adopt a prototype or individually designed SEP instead. Practically, many S-corps set up the plan through a financial institution that provides the paperwork and custodial accounts.
Establishing Eligibility and Participation Rules for Employees
Your plan needs clear participation terms, and you must apply them correctly. The IRS outlines baseline eligibility rules (age, service history, and minimum compensation), and employers may choose rules that are less restrictive but not more restrictive.
Also, when you decide to contribute for a year, your contribution rate must be uniform for eligible employees, and you generally must include eligible employees who performed services during that year—even if they left before the contribution is made. If you have employees, that uniformity rule is the heart of SEP compliance.
Deadlines for Contributions and Plan Establishment
One major advantage of a SEP is timing flexibility. You can set up a SEP for a year as late as the due date (including extensions) of your business income tax return for that year. Contributions are also due by the tax filing deadline (including extensions). For many S-corp owners, this means you can do year-end planning, finalize payroll and books, then fund the SEP after the year closes—so long as you meet the applicable filing deadline for the year in question.
Recordkeeping, Reporting, and Compliance Requirements
SEPs are lighter than 401(k)s, but they are not “set it and forget it.” Employers generally have no Form 5500 filing requirement for a SEP. On payroll reporting, the IRS guidance is clear that SEP contributions are not included on Form W-2 wages, but you typically check the “Retirement plan” box in Box 13.
You also have employee notice obligations: employees must receive required disclosures (for example, a copy of the plan document if you’re using the IRS model form) and an annual contribution statement. Strong documentation matters because SEPs are a common audit area when employee eligibility or contribution uniformity is mishandled.
Options for Custodians and Investment Management
A SEP IRA is held at a financial institution—banks, brokerages, insurance companies, and other qualified institutions can serve as trustees/custodians. Once contributions are made to each person’s SEP-IRA, employees generally control their own investments inside their accounts, choosing among the custodian’s available options.
From a business owner standpoint, the best custodian is usually the one that makes it easy to: open accounts for multiple employees, document contributions cleanly, provide annual statements, and support rollovers when appropriate.
Common Pitfalls and How to Avoid Them
Paying Yourself Too Little in W-2 Wages
The classic S-corp mistake is trying to minimize payroll taxes so aggressively that W-2 wages become too small to support meaningful SEP contributions. Because retirement plan contributions are based on compensation, an artificially low salary can shrink your maximum retirement contribution even if the business has plenty of cash flow. The fix is not “jack up wages blindly,” but to set reasonable compensation and align payroll planning with your retirement goal early enough in the year to avoid last-minute scrambling.
Missing Deadlines for Employee Contributions
A SEP gives you flexibility, but it still has hard deadlines. If you miss the due date (including extensions) for the business tax return, you can lose the intended deduction timing and create a compliance mess—especially if you were also trying to establish the plan for that year. Treat SEP funding like a formal year-end task with a checklist: confirm who is eligible, confirm the contribution percentage, confirm payroll numbers, and document when the contributions are sent.
Overlooking Required Employee Inclusion Rules
Some owners assume a SEP is “just for me.” It can be, but only if you truly have no eligible employees. If you have eligible employees, you typically must contribute for them whenever you contribute for yourself, using a uniform contribution rate. Missing an eligible employee, excluding part-time staff incorrectly, or forgetting someone who worked earlier in the year can create an expensive correction later.
Failing to Maintain Documentation for IRS Compliance
SEPs are simple, but the IRS still expects you to run the plan according to the written document. That means keeping the adoption agreement, the compensation definition used, proof that employee notices were provided, contribution calculations, and proof of funding. Documentation is also your best defense if you ever need to show that you applied eligibility rules consistently and funded everyone correctly.
Ready to Set Up Your SEP IRA the Right Way?
If you want your SEP IRA to be compliant, maximized, and painless at tax time, the key is coordinating payroll, bookkeeping, and retirement planning—not treating them like separate projects. Small Business Taxes LLC can help you structure W-2 wages appropriately, calculate contributions correctly, and keep clean records so your return is defensible.
