SEP IRA vs. Roth IRA: Which is Better for You?

Deciding on a simplified employee pension (SEP) IRA vs. a Roth IRA might not be an easy decision. Business owners now have a strong retirement savings account with the SEP IRA to store large sums of money for their future. For most people, a very flexible option for retirement savings is a Roth IRA.

Both have their advantages and disadvantages. A sound retirement plan necessitates investors to balance the advantages and disadvantages.

Choosing the right retirement savings plan can be a complex decision, especially when you’re weighing the pros and cons of different options. Two popular choices are SEP IRAs and Roth IRAs, each offering unique advantages and drawbacks. This guide will delve into the key features of both plans, helping you determine which one aligns best with your financial goals and circumstances.

Key Differences Between SEP and Roth IRAs

Contribution Limits:

SEP IRA: The lesser of 25% of your compensation or $66,000 for 2023, $69,000 for 2024. This allows for significantly higher contributions compared to Roth IRAs.
Roth IRA: $6,500 for 2023, $7,000 for 2024, with an additional $1,000 catch-up contribution for individuals aged 50 and above.

Tax Treatment:

SEP IRA: Contributions are tax-deductible, but withdrawals are taxed as ordinary income in retirement.
Roth IRA: Contributions are made with after-tax dollars, but qualified distributions (both contributions and earnings) are tax-free in retirement.

Required Minimum Distributions (RMDs):

SEP IRA: Yes, RMDs are required starting at age 72 (or 73 if born between 1951 and 1959, 75 if born in 1960 or later).
Roth IRA: No, RMDs are not required during your lifetime.

Eligibility:

SEP IRA: Available to self-employed individuals and small business owners.
Roth IRA: Available to individuals with modified adjusted gross income (MAGI) below certain limits.

When a SEP IRA Might Be a Better Choice:

High Earners: If you have a high income, the higher contribution limit of a SEP IRA can allow you to save more for retirement.
Tax Deductions: The immediate tax deduction on contributions can be beneficial if you are in a high tax bracket.
Self-Employed Individuals: SEP IRAs are specifically designed for self-employed individuals and small business owners.

When a Roth IRA Might Be a Better Choice:

Tax-Free Withdrawals: The tax-free nature of qualified distributions in retirement can be advantageous, especially if you anticipate being in a higher tax bracket then.
No RMDs: You don’t have to worry about taking RMDs with a Roth IRA, offering more flexibility in managing your retirement funds.
Lower Income Earners: Roth IRAs may be more accessible for individuals with lower incomes who don’t qualify for a SEP IRA due to income limitations.

Additional Considerations:

Investment Options: Both SEP and Roth IRAs offer a wide range of investment options, allowing you to tailor your portfolio to your risk tolerance and financial goals.
Contribution Flexibility: With a Roth IRA, you can choose to contribute any amount up to the annual limit, while SEP IRA contributions are based on your income.
Estate Planning: Roth IRAs can be advantageous for estate planning purposes, as they can be passed on to beneficiaries tax-free.

The best choice between a SEP IRA and a Roth IRA depends on your individual circumstances and financial goals. Consider factors such as your income, tax bracket, retirement plans, and investment preferences. If you’re unsure which option is right for you, consulting with a financial advisor can provide valuable guidance.

Here are some additional resources that you may find helpful:

Investopedia: SEP IRA vs. Roth IRA: What’s the Difference?
SmartAsset: SEP IRA vs. Roth IRA: What You Should Know
Internal Revenue Service (IRS): Retirement Plans

By carefully analyzing your financial situation and understanding the key differences between SEP and Roth IRAs, you can make an informed decision that aligns with your long-term retirement goals.

What are the disadvantages of SEP IRA?angle-downangle-up

There are a few drawbacks to a SEP IRA. First, company owners cannot make large contributions to their accounts without also making large contributions to the accounts of eligible employees. This is because each eligible employee must receive the same percentage of compensation from the business.

Second, unlike a 401(k), a SEP IRA does not have an employee contribution component, which could restrict your maximum contribution amount. Lastly, withdrawals made before the age of twenty-59%201/2%20 are subject to a 10% tax penalty in addition to regular income tax.

Why is a Roth IRA better than a SEP IRA?angle-downangle-up

For two reasons, a Roth IRA may be preferable to a SEP IRA. First, before reaching the age of 59 1/2, owners are free to withdraw contributions and conversions. Second, withdrawals are tax-free, helping keep taxes low in retirement.

SEP IRA vs Solo 401K: Which is Best for Self-Employed?

FAQ

What is the downside of SEP IRA?

If you set up a SEP, all employees must be included if they meet certain IRS-defined eligibility requirements. Equal contributions. Each employee must receive the same contribution as a percentage of salary. If you have more than a few employees, this may limit your ability to make large contributions for yourself.

Can you max out a SEP IRA and a Roth 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.

Should I convert SEP IRA to Roth?

Generally, a Roth IRA conversion makes sense if you: Expect to be in the same or a higher tax bracket during retirement. Can pay the conversion taxes without using the retirement funds themselves. You live in a state with no income tax but will retire to a state that has income tax.

What is a key advantage of an SEP IRA?

Under a SEP, an employer contributes directly to traditional individual retirement accounts (SEP-IRAs) for all employees (including themselves). A SEP is easier to set up and has lower operating costs than a conventional retirement plan and allows for a contribution of up to 25 percent of each employee’s pay.

Is a SEP IRA better than a Roth IRA?

A SEP IRA can be better for some individuals than a Roth IRA. In particular, a SEP IRA is best for self-employed business owners with just a few employees looking to maximize their retirement savings. The high contribution limit allows them to save a lot of money and defer taxes on those contributions, saving them money upfront.

How much can a SEP IRA contribute to a Roth IRA?

While an SEP IRA allows for annual contributions up to $61,000, Roth IRAs cap contributions at $6,000 or $7,000, depending on your age. If you’re an employer of others, SEP IRAs can provide a retirement plan for your staff. But remember, when setting up SEP IRAs for more than one worker, you must make equal contributions for each person.

Is a SEP IRA a good investment?

A SEP IRA offers no catch-up contributions for people aged 50 and over. Another positive feature is that, unlike traditional IRAs, Roths aren’t subject to required minimum distributions during your lifetime. So, if you don’t need the money in your Roth IRA for living expenses, it can pass to your heirs when the time comes.

What is a Roth IRA & a SEP IRA?

A Roth IRA is designed for individuals only. Though Roth provisions are permitted in certain types of retirement plans (not including SEP IRAs), they are more typically stand-alone individual accounts. The maximum annual contribution is $7,000, or $8,000 if you’re age 50 or older.