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SEP IRA vs. Roth IRA: What You Should Know


If you’re self-employed, you may be weighing the pros and cons of SEP IRAs and Roth IRAs. Both are tax-advantaged savings vehicles that provide particular benefits. But before we explore those and compare them, it’s necessary to unpack who can invest in each and what the contribution limits are so you can make the best choice for your needs. Of course, you can always find a financial advisor to help you invest in a retirement plan instead.

What Is a Roth IRA?

A Roth IRA is a retirement-savings plan that allows you to invest with after-tax dollars. This means you pay income taxes on the money going in. However, you won’t face any taxes on eligible withdrawals. You can begin taking tax-free distributions once you reach age 59.5 as long as you’ve had your Roth IRA open for at least five years.

Some financial advisors recommend you invest in a Roth IRA if you expect to be in a higher tax bracket as you approach retirement. This move would protect your savings from an otherwise hefty tax burden, especially when you would need that money the most.

However, eligibility to invest in a Roth IRA depends on income. So these aren’t really best for affluent individuals.

Roth IRA Contribution Rules

Roth IRA account holders can contribute up to the 2023 annual maximum contribution limit of $6,500. If you’re 50 or older, though, you can make additional “catch-up” contributions of up to $1,000, for a total of $7,500. However, the actual amount you can contribute toward a Roth IRA each year depends on your income level.

To be eligible to contribute anything towards a Roth IRA for the 2023 tax year, your modified adjusted gross income (MAGI) can’t exceed $153,000 if filing single or $228,000 if married and filing jointly. However, even if you come in below those numbers, your contribution limit will begin to phase out at $138,000 (single) or $218,000 (married filing jointly).

These numbers will increase for the 2024 tax year. Your MAGI can’t exceed $161,000 if filing single or $240,000 if married and filing jointly. The contribution limit begins to phase out at $146,000 (single) or $230,000 (married filing jointly).

What Is a SEP IRA?

An SEP IRA is basically a retirement plan designed for self-employed individuals and small-business owners. SEP stands for “Simplified Employee Pension.” Thus, it works almost like a 401(k). But it lacks some of the more burdensome legal and administrative tasks associated with running such a 401(k). This is one of the reasons why it appeals to small-business owners who may not have the resources to run a large 401(k) plan for their employees.

The IRS allows only employer contributions to be made toward employee SEP IRAs. But if you’re self-employed, you’re your own boss of course. When you invest in a SEP IRA, you make pretax contributions. As a result, these contributions may be deductible on your next tax return. However, you’d pay regular income taxes on qualified withdrawals. You can generally make these once you reach age 59.5. But as with a Roth IRA, you have to meet certain requirements before you can invest in one.

SEP IRA Contribution Rules

To participate in an SEP IRA, you must meet the following qualifications:

  • Be at least 21 years old
  • Be a sole proprietor, business owner in a partnership, limited liability company, S corporation or C corporation, or earn self-employment income
  • Have worked for a business (or have been self-employed) for three of the past five years
  • Made at least $650 from this employer or in self-employment income during the past year

For 2023, a self-employed business owner may contribute the lesser of the following toward his or her own SEP IRA or employees’ SEP IRAs:

  • 25% of the salary
  • $66,000 (increases to $69,000 in 2024)

The IRS does not permit additional “catch-up” contributions for SEP IRAs. But as you can see, a SEP IRA can carry a maximum contribution limit that stands significantly higher than that of a Roth IRA.

But if you have employees, you must contribute the same salary percentage for each eligible worker as you do for your own plan. So if you contribute 15% of your own salary toward your SEP IRA, you must do the same for each employee. Thus, many financial advisors recommend these plans for business owners with few employees or for the self-employed.

SEP IRAs vs. Roth IRAs

SEP IRA vs. Roth IRA

One of the most appealing benefits of a Roth IRA is the fact that you can make qualified withdrawals that are 100% tax-free. So if you retire at a high income tax bracket or are still working when you reach age 59.5, you’d be avoiding a hefty tax burden.

And because you’ve already paid taxes on the contributions you made toward a Roth IRA, you can withdraw these funds at any time. Keep in mind, however, that this rule applies only to what you put in. You can’t take out earnings on your investments until you reach age 59.5 without facing a 10% tax penalty. Nonetheless, this benefit helps Roth IRAs work as both long-term retirement plans and emergency funds.

Also, unlike with SEP IRAs or traditional IRAs, you don’t have to begin taking required minimum distributions once you reach age 70.5. Beyond the potential for a high maximum contribution, SEP IRAs offer other benefits as well. For instance, your contributions as well as the ones you make for your employees may be tax deductible.

So let’s say you’re self-employed, and you contribute $10,000 toward SEP IRAs for yourself and your employees in 2023 and 2024. Depending on which tax bracket you fall in, you could potentially save thousands of dollars in income taxes based on your SEP IRA contributions alone. And because contributing with pretax dollars reduces your taxable income, contributing to a SEP IRA may open the door for additional tax deductions or credits.

In addition, you may invest in any options offered by the account provider that you opened your SEP IRA with. These typically include stocks, bonds and mutual funds. In some cases, your options may be more diverse than those found in a typical 401(k) or Roth IRA investment menu.

With that said, it’s important to set your asset allocation by age and risk tolerance before investing in either a SEP IRA or a Roth IRA. If you’re not sure what yours is, you can use our asset allocation calculator. It provides you with a glimpse of what your investment portfolio may look like based on your risk appetite.

How to Open a SEP IRA and a Roth IRA

These days, you can shop around at the best banks to find a Roth IRA you’d like. Some offer better interest rates than others, so doing your research is crucial. You can also open a Roth IRA through investment companies. Some of these firms will invest your money in mutual funds and other securities. Investment options, as well as fees, will also differ across different financial institutions. That makes it important to narrow your choices as best you can.

You can open a SEP IRA at most financial institutions, including banks and investment firms. It’s important to shop around, however. Some firms charge no application fees or annual maintenance fees for running a SEP IRA. Investment menus and other benefits may also differ across different providers.

If you’re an employer looking to establish a SEP IRA, the IRS offers the following guidelines:

  • Make a formal written agreement by filling out IRS Form 5305-SEP or get a similar one from your account provider
  • Provide eligible employees with IRS Form 5305-SEP
  • Establish individual accounts for each eligible employee

Can I Have Both a SEP IRA and a Roth IRA?

SEP IRA vs. Roth IRA

Yes, as long as you’re eligible to invest in both, no rule states you can’t open both accounts. You can even invest in both as well as a 401(k). So let’s say you have a regular 9-to-5 that sponsors a 401(k) plan, but you also run a side business. You can use your self-employment income to fund the SEP IRA.

If you max out both, you can go ahead and open a Roth IRA as long as you’re eligible. If you make too much money to open a Roth IRA, keep in mind that SEP IRA contributions reduce your taxable income. So you may end up qualifying for a Roth IRA if you contribute up to your SEP IRA maximum.

Bottom Line

Roth IRAs and SEP IRAs offer distinct tax advantages. But figuring out which is right for you ultimately depends on your preferences and financial situation. If you like the comfort of tax-free withdrawals, a Roth IRA may be right for you. This choice also may be appealing if you find comfort in the fact that you will be able to make qualified withdrawals tax-free. This perk is particularly beneficial if you expect to be in a high-income tax bracket as you approach retirement.

But if you run or plan to start a small business and can’t handle the burden of running a large 401(k) for yourself and your employees, a SEP IRA may be best for you. You can make tax-deductible contributions toward your plan and that of your employees, thereby fostering a beneficial working environment for all.

Tips on Retirement Planning

  • Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • SmartAsset’s retirement calculator can help you see if you’re on track for retirement.

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