SEP-IRA vs. Profit-Sharing Plan: Five Small Business Considerations

As a business owner, you know it’s important to attract and keep talented team members. One way to do that is to offer a retirement plan. While some business owners might want employees to contribute to the plan for themselves, you might not want to spend the time, hassle, and expense from having to make monthly (or more frequent) contributions to the plan coordinated with your payroll—like you would have with a 401(k) or SIMPLE Individual Retirement Account (IRA). The good news is there are other alternatives such as a SEP-IRA or a profit-sharing plan.

These choices are very similar and both allow you to offer retirement benefits to your employees, plus set aside money for your own retirement. As the business owner, you’ll make all the contributions to the plan and get the appropriate tax deductions. But it’s important to keep in mind that each alternative has its pros and cons. Here are five things to consider when deciding between a SEP-IRA and a profit-sharing plan.

Which Employees Will You Cover?

The first thing to consider is which employees you want to cover. Either plan can be an effective choice for sole proprietors, LLCs, and those with a side gig. If you don’t have employees, feel free to skip ahead to the next section. If you do have employees, any of them who meet the eligibility requirements in your plan will be covered, meaning in years where you make a contribution for yourself, you must make contributions for these eligible employees too.

SEP-IRA employee eligibility requirements are not as flexible if you have long-term employees. With profit sharing, you have a little more leeway.

In general for a SEP-IRA, you must cover any employee who has worked for you in at least three of the last five years. Whether an employee is full-time, part-time, seasonal help, or only works one day, working any part of a year counts as one year of service. Plus, so long as they earned at least $650 in 2022 (or that year’s annual limit if you are making a contribution for a different year), they’re eligible for a SEP-IRA contribution based on the income the employee earned in that year.

A profit-sharing plan, though, does not necessarily require you to cover some part-time workers. If someone hasn’t worked at least 1,000 hours for you in a year, including them is not mandatory. But if they do work at least 1,000 hours in a year, then they do get credit for a year of service. The maximum number of years you can require is two, but if you want a vesting schedule on plan contributions, then the maximum requirement is one year. It’s also possible to make other rules limiting employee participation in a profit-sharing plan, but make sure to follow the rules listed in your plan document. Use our Small Business Eligibility and Contribution Calculator to see which of your employees might be eligible in either plan.

Contribution Amount

Next, it’s important to understand how to handle contributions. After all, as an employer, you’re probably hoping to make your own contributions to the plan in addition to those for your employees. Maximum contributions in both plans are 25% of compensation up to $58,000 per person for 2021 or up to $61,000 if you are making a contribution for 2022. And remember all contributions come from the business.

The general rule with a SEP-IRA is that your contribution percentage (not a dollar amount) for each employee should equal what you put in for yourself. If you contribute 10% of your income to your own account, you will also put 10% of your employees’ pay into each of their accounts.

Profit-sharing plans allow an employer more flexibility. In addition to everyone in the plan receiving the same contribution percentage, some plans allow an age-weighted formula to give older workers a larger percentage than younger workers. As a business owner, you’re typically among the oldest workers in your company, so it’s one way to add a little extra to your retirement account. And you’ll need to make sure your specific profit-sharing plan document allows this age-weighted formula and that you hire a third-party administrator to make sure your contribution still meets IRS guidelines each year.

Of course, if you have no employees, then either plan will let you contribute the maximum of 25% up to $58,000 for 2021 ($61,000 for 2022). Make sure to try our handy Small Business Contribution Calculator to model different contribution levels — whether you have employees or not.

Flexibility and Commitment

This is where the SEP-IRA really shines. It’s the most flexible and least commitment-heavy plan for business owners. Whether you have employees or not, it’s possible to have a SEP-IRA for one year, make the contributions, and then never contribute again. You can also change contribution percentage amounts from year to year.

A profit-sharing plan, on the other hand, requires more solid commitments. The IRS encourages you to contribute to the plan about two out of every five years. It’s not codified, but it is a general rule if a business is considered an ongoing entity.

Both of these plans are fairly easy to set up. You can set up either a SEP-IRA or a profit-sharing plan for the previous year through your company’s tax filing deadline—including extensions. So, if you decide in 2023 that you could use a tax benefit for tax year 2022, you have until April 15 (for sole proprietors) to retroactively set up a SEP-IRA or a profit-sharing plan and contribute for yourself and your employees. And if you file an extension, you could do so as late as October 15. And it may not be too late to get a deduction for last year: If your company has a tax extension for 2021, you could still set up and make 2021 contributions to a SEP-IRA until October 17, 2022 (through your extension date).

TD Ameritrade does not provide tax advice. Clients should consult with a tax advisor with regard to their specific tax circumstances.

Potential Complexity

What forms do you fill out, and how do you maintain the plan? Complexity of administration can be a real issue with employee retirement plans. Let’s explore some key differences in the setup process for both plans.

Once you set up a SEP-IRA, and you’ve figured out what to contribute, the heavy lifting is finished. There’s no special tax paperwork, and ongoing administration is fairly simple. Your chosen vendor takes care of things from there. For example, if you select TD Ameritrade, we’d report contributions and distributions with the IRS. Once you put money in the accounts and take the tax deduction, you’re pretty much done with the administration.

Profit-sharing plans can sometimes be a little more complex. You’re required to file an annual Form 5500 with the IRS once your plan assets reach $250,000. You could handle it yourself, hire a firm specializing in plan administration, or get help from an accountant. Remember to keep track of fees paid for plan administration because you can deduct many of these plan costs as a company business expense. The more complexity you add to the plan, like age-weighted contributions and vesting schedules, the more complicated (and expensive) your tax filing and administration could become.

Carefully consider this aspect of plan administration to make sure the benefits outweigh the costs.

Control and Responsibility

Finally, when choosing between a SEP-IRA and a profit-sharing plan, consider the issues of control and responsibility. 

With a SEP-IRA, as soon as you contribute to your employees’ accounts, they can invest or withdraw like any other IRA, subject to the same benefits and penalties. Additionally, with the SEP-IRA, you can’t enforce a vesting schedule or require that employees work on the last day of the year to get a contribution. On the other hand, you’re not responsible for how they invest the money, and you aren’t required to provide specific investment choices.

Profit-sharing plans offer the employer a little more control over employee access. You can impose a minimum number of hours or years an employee must work for you before participating, and you can set up a vesting schedule to limit how they withdraw the money. However, with this control comes greater responsibility. You’ve got a fiduciary responsibility to provide a broad range of investment choices that work well for employees. If you don’t want to take on this task, you’ll need to hire an administrator or advisor who invests according to fiduciary principles.

Additionally, you can set a profit-sharing plan to allow loans, and you can loan yourself money from your own account and use the capital. This is one of the main reasons business owners may choose a profit-sharing plan. Before selecting this route, though, it’s important to determine whether this feature makes sense for your unique financial situation. Note that the TD Ameritrade profit-sharing plan no longer allows clients to offer a plan loan provision.

In the end, whether you choose a SEP-IRA or a profit-sharing plan depends on your goals and priorities as a small business owner and employer. Carefully weigh the choices and consult your tax advisor before choosing.