SEP-IRA vs. Profit-Sharing Plan: 5 Small Business Considerations

As a business owner, you know it’s important to plan for retirement and attract and keep talented employees. One way to do that is to set up a retirement plan. While some business owners might want employees to contribute to the plan themselves, you might want to consider a plan where the business makes the contributions, such as a SEP-IRA or a profit-sharing plan. These types of retirement plans can help with employee retention by offering additional compensation in the form of contributions to the plan and includes benefits for business owners, such as high contribution limits and tax deductions.

Both of these plans are very similar, but it’s important to keep in mind that each 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?

First, consider 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 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.

Generally for a SEP-IRA, you must cover any employee who has worked for you 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 $750 in 2023 (or that year’s annual limit if you’re 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 you follow the rules listed in your plan document. 

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. The maximum contribution for each employee is 25% of their compensation up to $66,000 per person for 2023 or up to $69,000 if you’re making a contribution for 2024. For you (the business owner), the contribution limit is generally 20% of net income (figured without deducting owner contributions) but not more than the dollar limits above. And remember all contributions come from the business.

The general rule with a SEP-IRA is that the 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’ll also put 10% of your employees’ pay into each of their accounts.

Profit-sharing plans allow an owner a bit 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. But be aware, you’ll need to make sure your specific profit-sharing plan document allows this age-weighted formula and that you’ll want to hire a third-party administrator to make sure your contribution still meets IRS guidelines each year.

Make sure to try our handy Small Business Contribution Calculator to model different contribution levels—whether you have employees or not.

Flexibility and commitment

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 a more solid commitment. While contributions are not required each year, for the plan to be considered ongoing by the IRS, there must be “recurring and substantial” contributions being made. If contributions have not been regular, the IRS may consider the plan to be discontinued, which could result in the plan being terminated. 

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. Once you put money in the accounts and take the tax deduction, you’re pretty much done with the administration.

Profit-sharing plans can be a little more complex. Generally, 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 taxes and penalties. Additionally, with a SEP-IRA, you can’t enforce a vesting schedule or require 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 to the funds. You can impose a minimum number of hours or years an employee must work before participating in the plan, 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.

Bottom line

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.