SEP IRA vs. Roth IRA: What’s the Difference? – Empowered Finances, LLC
There are multiple varieties of individual retirement accounts or IRAs, for short.
Two available versions are the SEP-IRA and the Roth IRA. So, what are they? And, can you choose to have one or the other? – or even both?
In fact, a reader submitted this exact question:
|“I have a question about the SEP & Roth IRA. If My employer doesn’t offer any kind of retirement benefits. But I do have my own Roth and from Previous employment Rollover IRA. I am regularly contributing to my Roth IRA.
Also I would like to contribute to SEP or simple IRA. Is it ok to contribute each plan with out any penalty?
Also, I am above 50. What is the best route to contribute above mention IRA’s and not get penalty?”
Let’s dig down and take a closer look at the SEP IRA vs. a Roth IRA mystery.
The goal is to help you see the virtues – and disadvantages – of each so you can make an informed decision about which will be the right choice for you.
What is a SEP IRA and How Does it Work?
A Simplified Employee Pension plan, or simply “SEP IRA” for short, is part IRA, part pension plan. The IRA part is that it works much the way a traditional IRA does. But the pension side is that if you own a business and have employees, you can include those workers in the plan.
The word “simplified” is included in the name because a SEP IRA is easier to set up and administer than traditional pension plans, like 401(k) plans.
A SEP IRA can be set up in just three steps:
- Execute a written agreement to provide benefits to all eligible employees.
- Give employees certain information about the agreement.
- Set up an IRA account for each employee.
The last step requires some additional explanation. Unlike most employer pension plans, all participants are not included in a single plan. Once the plan is established, each participant – you included – will have his or her own IRA account. The account can be set up with a bank, insurance company, or qualified investment broker.
Since a SEP IRA is an IRA, it can be self-directed and invested in any asset class not prohibited by the IRS.
You can also set up a SEP IRA for yourself alone, if you’re self-employed, and have no employees. But that will give you the flexibility to add employees should you decide to hire them later. And the fact that you will be offering some sort of retirement plan be an incentive for people to work for you.
General Provisions of a SEP IRA
In most respects, a SEP IRA is like a traditional IRA on steroids:
- A SEP IRA can be established for a sole proprietorship, partnership, corporation (S or C), or a limited liability company (LLC).
- Contributions are tax-deductible in the year taken.
- Contributions can be made from earned income only.
- You are not required to make contributions each year.
- Contributions must be made by the tax filing today, generally, April 15 (but including extensions).
- Investment income accumulates on a tax-deferred basis.
- Unlike other retirement plans, a SEP IRA cannot have a Roth provision.
- Distributions taken after reaching age 59 ½ are taxable as ordinary income.
- Distributions taken before reaching age 59 ½ are subject to ordinary income tax, plus a 10% early withdrawal penalty.
- Required minimum distributions (RMDs) must begin at age 72.
>> Related: SEP IRA Distribution Rules
SEP IRAs have an important tax benefit that doesn’t get a lot of attention, but it’s huge.
SEP IRA contributions are not subject to FICA (Social Security and Medicare) or federal unemployment (FUTA) taxes.
401(k) plans, for example, do not have the same advantage. You’ll pay both FICA and FUTA tax on your entire income, including your 401(k) plan contributions.
IMPORTANT: The SEP IRA is one of the few retirement plans that does not offer a “catch up contribution” for participants over the age of 50. The maximum contribution limit of $61,000 stands regardless of your age.
SEP IRA Contribution Limits
Traditional and Roth IRAs have a fixed annual contribution limit. This is not the case with a SEP IRA.
The maximum you can contribute to a SEP IRA is based on your income. You can contribute up to 25% of your net business income, up to a maximum of $61,000 for 2022.
“A SEP IRA is typically an appropriate structure for a small business, especially a single owner and allows for a contribution of up to 25% of an employee’s pay by the employer,” advises Jacqueline Reeves, Managing Director of Bell Rock Capital LLC.
“The SEP IRA contributions are before-tax. Depending upon the plan structure, SEP IRAs could permit employees to contribute like they would be able to a traditional IRA.”
But the contribution calculation isn’t quite as simple as taking 25% of your net income. Before applying 25% to your income, you must first deduct the amount of the contribution itself.
It’s confusing, of course, but the net result is that you’ll effectively be contributing 20% of your net income.
Let’s work out an example, assuming the maximum allowable income.
Your total compensation from your business is $305,000. If you multiply $305,000 by 25%, you get $76,250. But you’ll be limited to contributing no more than $61,000 for the year.
In reality, the calculation looks like this:
$305,000 net income, minus the $61,000 contribution = $244,000 X 25% = $61,000
So, if you’re looking for a quick calculation to determine your allowable SEP IRA contribution, just use 20% of your business net income.
My recommendation is that you hire a CPA to handle your income tax preparation if you have a SEP IRA. That’s especially true if you have employees participating in the plan.
There’s still another complication. In addition to deducting your own contribution to the SEP IRA before making the calculation, you must also reduce that income by one-half of your self-employment tax.
Yeah, hire a CPA!
What About Employee Contributions?
If your SEP IRA does include employees, you must use the same percentage of compensation for every employee participating in the plan. You, as the employer, will make the contributions – not your employees. But those contributions will be tax-deductible to you.
If you choose to contribute 25% of your income to the plan, you must contribute the same percentage to your employee’s accounts. Similarly, each employee will also be subject to the $61,000 maximum contribution (for 2022).
Contributions, when made by the employee, immediately become the property of the employee. There is no vesting requirement.
What is a Roth IRA and How Does it Work?
Even though they’re both IRAs, a Roth IRA bears little resemblance to a SEP IRA. It’s much more like a traditional IRA, though with special provisions.
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 $6,000, or $7,000 if you’re age 50 or older.
But this is where the unique advantage of the Roth IRA enters the picture.
>> See: Best Places to Open a Roth IRA
Roth IRA Contribution Limits
Annual contributions to a plan are not tax-deductible. However, once you reach age 59 ½, and have participated in a plan for at least five years, you can begin taking withdrawals completely tax-free. That includes both the contributions you’ve made over the years and the income you’ve earned within the account.
Roth IRAs have another tax advantage over other retirement plans. Since plan contributions are not tax-deductible, they can be withdrawn prior to age 59 ½ with no income tax consequences. That means no ordinary income tax, and no 10% early withdrawal penalty.
Important: Roth IRA’s Offer Tax-Free Withdrawals
The benefit applies to the contributions only, not to the income they earned within the plan. Early withdrawal of the income portion of your plan prior to turning age 59 ½ will be subject to ordinary income tax, and the 10% early withdrawal penalty.
Fortunately, the IRS allows you to first withdraw out of your contributions, then the income portion only once your contributions have been completely withdrawn from the plan.
This benefit is unique to the Roth IRA. That’s the reason some financial advisors recommend using the plan as a combination emergency fund and retirement plan.
“The main attraction of a Roth IRA is the 100% tax-free withdrawal it offers,” points out Lyle Solomon, Principal Attorney at Oak View Law Group. “You can withdraw from a Roth IRA account anytime you want, as you have already paid taxes for the invested funds.
But keep in mind that you do have to pay a 10% tax penalty for withdrawals of any earnings on your investments unless you are older than 59 1/2. So, the easy accessibility of a Roth IRA also makes it an emergency fund.
Still, another benefit of a Roth IRA over a SEP IRA is that you do not have to start taking required minimum distributions after the age of 72.”
>> Related: Roth IRA Rules and Contribution Limits
Roth IRA Income Limits
Roth IRA contributions are permitted only up to certain income limits. For 2022, you are eligible to make a Roth IRA contribution up to the following income limits:
- Married filing jointly, or qualifying widow(er), full contribution up to a modified adjusted gross income of $204,000, gradually phasing out up to $214,000.
- Married filing separately, and you lived with your spouse at any time during the year, reduced contribution permitted up to an income of $10,000, then prohibited.
- Single, head of household, or married filing separately and you did not live with your spouse at any time during the year, fully deductible up to an income of $129,000, then phased out at an income of $144,000.
The income limits are another area where the Roth IRA departs from a traditional IRA.
With a traditional IRA, income limits limit or eliminate your ability to make a tax-deductible contribution if you are covered by an employer-sponsored plan. But you can still make a non-tax-deductible contribution, even if you exceed those income limits.
Not so with the Roth IRA. Though you can have a Roth IRA with an employer-sponsored plan, you cannot make any contribution at all if your income exceeds the IRS limits shown above.
You can maintain a Roth IRA in conjunction with an employer-sponsored plan, including a SEP IRA. But the total contributions between the two plans cannot exceed $61,000.
Roth IRA General Provisions
The general provisions of a Roth IRA are very similar to a traditional IRA, other than the tax consequences.
Roth IRA’s = tax-free money! 🙌🏼
- Contributions are not tax-deductible in the year taken.
- Contributions can be made from earned income only.
- Your plan can be held in a financial institution of your choice and invested in any asset classes not prohibited by the IRS.
- You are not required to make contributions each year.
- Contributions must be made by the tax filing date, which is generally April 15. But that does not apply to extensions.
- Investment income accumulates on a tax-deferred basis.
- Distributions taken after reaching age 59 ½ are tax-free as long as you’ve participated in a Roth plan for at least five years.
- Distributions of the income portion of your plan taken before reaching age 59 ½ are subject to ordinary income tax, plus a 10% early withdrawal penalty.
- Roth IRAs are not subject to required minimum distributions (RMDs). You can literally allow them to continue to grow for your entire life.
SEP IRA Advantages
- You can make larger contributions than you can with a traditional or a Roth IRA. The maximum contribution for a traditional or Roth IRA is just $6,000, while the maximum for a SEP IRA is $61,000.
- Your contributions to a SEP IRA are deductible for FICA and FUTA taxes, in addition to federal and, most state income taxes.
- The plan can be set up to include employees.
- You can set up an individual plan as a sole practitioner, then add employees as you hire them.
- Each employee can maintain his or her own IRA account within the plan.
- Easy retirement plan to set up and maintain.
- A SEP IRA is a completely self-directed plan. You can open an account with any financial institution you choose and invest in any asset class not prohibited by the IRS.
- Contributions can be made as late as your tax filing date, or the tax extension date.
Roth IRA Advantages
- Withdrawals taken from a Roth IRA are completely tax-free once you reach age 59 ½ and have been participating in a Roth plan for at least five years.
- Accounts are self-directed and can be invested wherever you want, and in just about any type of investment.
- Since your contributions are not tax-deductible, they can be withdrawn before reaching age 59 ½. Ordinary income tax and the 10% early withdrawal penalty will not apply. This applies to contributions only, not to investment income amounts earned within your plan.
- You can have a Roth IRA, along with an employer-sponsored plan as long as the total contributions to all plans don’t exceed the IRS maximum limit.
- Roth IRAs are the only retirement plan not subject to required minimum distributions at age 72. You can keep your plan for your entire life.
>> More: 7 Roth IRA Secrets You Wish You Knew Sooner!
SEP IRA Disadvantages
- Since SEP IRA contributions are based on a percentage of your income (effectively 20%) you’ll need a net income from your business of at least $30,000 before a SEP offers larger contribution limits than a traditional or Roth IRAs.
- There is no catch-up provision if you’re 50 or older.
- Like most retirement plans, required minimum distributions apply to SEP IRAs, beginning at age 72.
- All eligible employees, if you have any, must be included in the plan, and you must make contributions on their behalf. The contribution percentage of their income must be identical to your contribution percentage.
- Even though it’s an IRA, a Roth provision cannot be added to a SEP IRA.
- Since the contribution calculation is complicated, you’ll almost certainly need to hire a CPA to prepare your income tax return.
Roth IRA Disadvantages
- Contributions to the plan are not tax-deductible.
- If you exceed IRS income limits for the plan, you cannot make Roth IRA contributions.
- The maximum contribution is limited to just $6,000, or $7,000 if you are 50 or older.
Can I Have Both a SEP IRA and a Roth IRA?
The short answer is a resounding yes! Though a SEP IRA cannot contain a Roth provision, you can have a SEP, and set up your own Roth IRA account.
The only limitation is that your total contributions to both plans cannot exceed the IRS limit of $61,000. That means you can allocate $55,000 to your SEP IRA, and $6,000 to a Roth IRA.
In fact, having both plans in place at the same time will give you the benefit of a large tax deduction provided by the SEP IRA, along with tax diversification in retirement through the Roth IRA.
The Roth IRA will give you a source of tax-free income to supplement taxable income from other sources. That can keep you in a lower tax bracket during retirement when your income may be surprisingly higher than you expect.
“It is possible, and feasible, to have both a SEP IRA and a Roth IRA,” recommends Sallie Mullins Thompson, CPA/PFS, CFP, CDFA at Sallie Mullins Thompson CPA PLLC. “It’s my opinion that everyone needs a Roth IRA which should be funded to the same extent as tax-deferred retirement plans and which provides a tax-free source of income in retirement. Starting as early as possible with a Roth IRA is recommended since the earnings grow tax-deferred and are withdrawn tax-free, assuming all regulations are followed.”
Even if you qualify to make the full $61,000 contribution through a SEP IRA, plan to reduce the contribution and redirect $6,000 into a Roth IRA.
Though we’ve titled this article SEP IRA vs. Roth IRA, it really isn’t a competition. In truth, the two plans are completely complimentary. That’s the reason why you should have both.
The SEP IRA offers a very large contribution amount. That will not only reduce your taxes between now and retirement, but it will also enable you to build a very large retirement nest egg.
But a Roth IRA is truly one of the most generous retirement plans offered by the IRS. It’s the only one that will both provide you with tax-free income in retirement and exempt you from required minimum distributions at age 72.
That last point is particularly important. One of the biggest concerns of retirees is outliving their money. Since you can keep your Roth IRA past age 72, and allow it to continue to earn and grow, it can serve as the retirement account of last resort as other plans become depleted. You don’t have to choose between a SEP IRA and a Roth IRA – you can have both!