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SEP IRA vs. Roth IRA

If you’re self-employed, you may be weighing the SEP IRA vs. Roth IRA decision. 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 that’s right for you.

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. In fact, the Trump Tax Plan may have already dropped you to a lower one.

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

Who Can Invest in a Roth IRA and What are the Contribution Limits?

To be eligible to contribute toward a Roth IRA in 2018, your modified adjusted gross income (MAGI) can’t exceed $135,000 if filing single or $199,000 if married filing jointly.

In 2019, the income limit for single filers climbs to $137,000. It rises to $203,000 for those married filing jointly and qualifying widowers.

If you meet these requirements, you may contribute up to the maximum Roth IRA contribution limit. For 2018, that limit is $5,500 if you’re younger than age 50. But if you’re better than 50-years-old, you can make additional “catch-up” contributions of $1,000 for 2018.

In 2019, the Roth IRA contribution limit increases to $6,000. The catch-up contribution stays at an additional $1,000 if you’re eligible.

However, the actual amount you can contribute toward a Roth IRA each year depends on your income.

In 2018, “phase-out” levels kick in for single filers when their MAGI exceeds $120,000. They start at $189,000 for those married filing jointly. What this simply means is that once you pass those thresholds, the IRS brings down the amount you’re allowed to contribute each year until you make so much that you’re not allowed to invest in one at all.

In 2019, phase-out levels begin at $122,000 for single filers and $193,000 for those married filing jointly.

Benefits of a Roth IRA Over an SEP 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.

And unlike with SEP IRAs or traditional IRAs, you don’t have to begin taking required minimum distributions once you reach age 70.5.

How Do I open 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 menus as well as fees will also differ across different financial institutions, so it’s important to narrow your choices as best you can.

What is an SEP IRA?

SEP IRA vs. Roth 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 pre-tax 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.

Who Can Open a SEP IRA and What Are the 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 $600 from this employer or in self-employment income during the past year

For 2018, a self-employed business owner may contribute the lesser of the following toward his or her own SEP IRA and/or employees’ SEP IRAs:

  • 20% of salary
  • $55,000

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.

Benefits of an SEP IRA Over a Roth IRA

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 contributed $10,000 toward SEP IRAs for yourself and your employees in 2018. If you fall in the 25% tax bracket, you could potentially save $2,500 on the year’s income taxes based on your SEP IRA contributions alone.

And because contributing with pre-tax 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 Do You Open an SEP IRA?

You can open a SEP IRA with 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 interested in establishing 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 Open a Roth IRA and a SEP IRA?

As long as you’re eligible to invest in either one, no rule states you can’t open both a Roth IRA and a SEP IRA. 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. And if you max out both, you can go ahead and open a Roth IRA as long as you’re eligible. And 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 toward your SEP IRA maximum.

The Takeaway: SEP IRA vs. Roth IRA

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 being able to withdrawal your own contributions penalty free, 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 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.

SEP IRA vs. Roth IRA

Tips on Retirement Planning

  • Your retirement savings options aren’t limited to an SEP IRA or a Roth IRA. You can also invest in a traditional IRA, which functions similarly to a 401(k) plan in reducing your tax liability.
  • Any time you’re contemplating retirement planning decisions, a financial advisor can provide expert guidance. If you’re interested, you can use our SmartAsset financial advisor matching tool. It provides you with information on up to three financial advisors in your area. You can review their qualifications and credentials before you decide which one to work with.

Photo credit: ©iStock.com/svetikd, ©iStock.com/designer491, ©iStock.com/milanvirijevic

Javier Simon, CEPF® Javier Simon is a banking, investing and retirement expert for SmartAsset. The personal finance writer's work has been featured in Investopedia, PLANADVISER and iGrad. Javier is a member of the Society for Advancing Business Editing and Writing. He has a degree in journalism from SUNY Plattsburgh. Javier is passionate about helping others beyond their personal finances. He has volunteered and raised funds for charities including Fight Cancer Together, Children's Miracle Network Hospitals and the National Center for Missing and Exploited Children.
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