Does an SEP IRA Withdrawal Count as Taxable Income?
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If you have money saved in a Simplified Employee Pension (SEP) IRA, you may be wondering what happens when you finally take the money out. Withdrawals from a SEP IRA are counted as taxable income. Like a traditional IRA, the SEP allows your savings to grow tax-deferred, but once you start drawing down funds, the IRS wants its share.
How Withdrawals Are Taxed
A SEP IRA operates under the same rules as a traditional IRA. Contributions go in on a pre-tax basis, and both contributions and any earnings grow tax-deferred. Once you withdraw the money, the full amount is taxed as ordinary income in the year you receive it.
For example, if you take out $25,000 from your SEP IRA in retirement, that amount will be added to your taxable income for the year. It does not matter if the withdrawal came from employer contributions or investment growth. Unlike long-term capital gains from a brokerage account, SEP IRA withdrawals are not eligible for lower tax rates.
Early Withdrawal Penalties
If you withdraw money from a SEP IRA before age 59 and a half, you will generally owe not only income tax but also a 10% penalty on the amount you take out.
There are some exceptions. The penalty may be waived if the money is used for certain qualified expenses, such as unreimbursed medical costs, health insurance premiums while unemployed, higher education costs, or up to $10,000 toward a first-time home purchase. Disability and certain distributions to military reservists also qualify for exceptions. Even in these cases, though, the distribution is still taxable income. Only the 10% penalty is avoided.
Required Minimum Distributions
Tax deferral does not last forever. Once you reach age 73, you must begin taking required minimum distributions, or RMDs, from your SEP IRA. The IRS calculates your annual withdrawal requirement based on your account balance and life expectancy.
Failing to take the RMD comes with a penalty equal to 50% of the amount that should have been withdrawn. These RMDs are taxed as ordinary income just like any other withdrawal, regardless of whether you still work for the employer that set up the plan.
Rolling Over Your SEP IRA
One way to maintain flexibility is through rollovers. SEP IRA assets can be rolled into another traditional IRA or into certain qualified retirement plans without triggering taxes at the time of the rollover. This is useful if you leave your business or want to consolidate accounts. However, once you begin taking distributions, the tax rules apply the same way as if the funds had stayed in the SEP IRA.
Why it Matters for Retirement Planning
Understanding the tax treatment of SEP IRAs can help you plan withdrawals strategically. Because distributions are taxed as ordinary income, the timing and size of withdrawals can push you into a higher tax bracket. Some retirees plan to spread withdrawals over several years to avoid big spikes in taxable income.
Small-business owners also need to balance the benefits of making large SEP contributions today, since they reduce taxable income for the business against the reality that withdrawals later will be taxed.