A Simplified Employee Pension (SEP) IRA plan allows self-employed individuals and small business owners to contribute to both their employees' retirement and their own.

SEP-IRAs are attractive because they can allow you to sock away significantly more savings than a traditional IRA. However, they may also come with a higher overall cost to your business if you have several eligible employees.

So, what is an SEP-IRA, exactly? Read on to learn about how they work and how they compare to traditional IRAs and pension plans.

What Is a Traditional IRA?

A traditional individual retirement account (IRA) is a savings vehicle you can use to set aside tax-deferred money for retirement. You can contribute up to $6,000 per year (or $7,000 if you're age 50 or older) and pay the associated taxes when you take distributions in retirement. This money is pretax in that you claim the deduction on your taxes and your taxable income is lesser due to your contribution. Traditional IRAs can invest in a number of different assets, including stocks, bonds, mutual funds, exchange-traded funds and more.

Traditional IRAs don't relate to an employer, and you can make contributions every year in which you or your spouse has earned income.

What Is an SEP-IRA?

SEP-IRA stands for simplified employee pension individual retirement account. An SEP-IRA functions a little differently from a traditional IRA, though it still allows for pretax retirement contributions.

When self-employed individuals and small business owners contribute to these accounts, they can claim tax deductions on their tax return, lowering their taxable income for the year of contribution. This allows your contributions to grow in a tax-deferred manner in investments held in the account until withdraw in retirement and taxed as income.

How Does an SEP-IRA Work?

An SEP-IRA works best for self-employed individuals and small business owners who have few or no employees. SEP-IRA rules require eligible participants to receive the same percentage contribution of earnings as you give yourself. Depending on how much you'd like to contribute to your own SEP-IRA, contributing to every eligible employee's plan as well could quickly add a higher expense than you originally wanted.

For example, if you wished to contribute a larger share of your earnings, say 20%, you'd also have to match this contribution percentage for every eligible employee. If an employee earns $50,000, they'd be entitled to $10,000 from you to contribute toward their SEP-IRA plan.

Depending on the income of your business, you can contribute a lot to your SEP-IRA, up to 25% of your compensation or $58,000 in 2021. This compares favorably with a traditional IRA, which only allows $6,000 per year, though SEPs don't allow catch-up contributions for people who are 50+ as traditional IRAs do.

Another nice attribute of SEP-IRAs is that they can allow you to contribute to both an SEP and a traditional or Roth IRA. For employees, this is particularly important, as SEP contributions made by your employer don't reduce how much you can contribute to your own IRA. Employers can also take advantage of both sets of accounts.

However, the amount you can deduct with a traditional IRA contribution may be reduced above certain income levels due to participation in both plans.

How Does an SEP-IRA Compare to a Pension?

Pensions haven't fared well in the last few decades due to their high contribution costs and legal liabilities to make pension funds whole over time. As a result, many companies have stopped offering this benefit to employees and are opting instead for defined contribution plans, such as a 401(k).

If you have a cyclical business with booms and busts, you can contribute more to an SEP-IRA in your high years and less in your low years. The flexibility of an SEP-IRA can give your business planning an easier time if cash flow is an issue at times. If you're self-employed or only employ a few workers, SEP-IRAs can work well as an alternative to defined contribution and defined benefit plans by building in high contribution limits and financial flexibility.