Before choosing a retirement plan, you should understand your financial situation, retirement goals, and preferences. If you are trying to find out which IRA is better, do not worry. We will explore both accounts, their pros and cons, and their points of difference. The goal is to help you decide which one will be suitable for you.
If you are self-employed and want to open a savings account for retirement, a Roth IRA and a SEP IRA are popular options. Both offer tax advantages, and opening and managing accounts in both IRAs is easy. However, the difference lies in tax treatment, contributions, and eligibility criteria.
What is SEP IRA, and how it Works?
Simplified Employee Pension (SEP) Individual Retirement Accounts (IRA) are retirement accounts for small business owners. It offers retirement plans to the owners and their employees. In a traditional IRA, 100% of the responsibility is on the employer's part for contribution, but a SEP IRA is fully controlled/owned by the employee.
Employers can contribute 25% of the employee's compensation up to a maximum value of $69,000 in 2024. As per the contribution in SEP IRA, each employee will get the same percentage of their compensation. In case a business owner contributes 25% of the compensation in his own IRA contributions, 25% of their employees' salaries should also be contributed.
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Employees don't need to pay income tax on their employers' contributions, because contributions to a SEP IRA are tax-free. You also don't need to pay tax on your investments, as the funds are in your retirement account. However, at the time of withdrawal, you have to pay income tax. There are a few rules of SEP IRA you should know other than taxation and contribution limits:
- Employers can exclude employees from the SEP IRA contribution if they are younger than 21 years of age or haven't worked for the company for the last 3 to 5 years.
- Like other retirement accounts, you must pay a 10% additional tax if you withdraw earnings from your SEP IRA before 59 1/2.
What is a Roth IRA, and how does it Work?
It's an individual retirement account in which you must pay taxes on your invested money. You will pay income taxes during your retirement and don't need to spend a sort of tax at the time of withdrawal. After the age of 59.5, you can withdraw your earnings without tax, but you have to wait for at least five years more to distribute funds.
If you are reaching a higher tax bracket as you approach retirement, some financial advisors suggest you invest in a Roth IRA. This will save you from a hefty tax burden and protect your savings amount. Eligibility to create a Roth IRA depends upon your earned income.
The maximum annual contribution limit for Roth IRA account holders is $6,500 in 2023. If you are 50 or older, you can add an additional $1,000 to the contribution limit to make a total of $7,500. The amount you can contribute to your Roth IRA depends on your income level.
To contribute to a Roth IRA, your MAGI should not exceed $161,000 if you are using the account alone, and if you are filing jointly, the limit shouldn't exceed $240,000 in 2024. The contribution limit for joint filing is $230,000, and single filing is $146,000.
What are the Key Difference between Roth IRA and SEP IRA?
The key difference lies in contribution limits, eligibility criteria, tax deduction and penalty on withdrawal.
Features | Roth IRA | SEP IRA |
Eligibility | The income limit must fall below the terms and conditions of the Roth IRA. | The employers' age should be greater than 21, and should have worked in the company for the last 3 to 5 years. |
Who can contribute? | Individual | Employer |
Tax deduction for contribution | No | Yes |
Tax on withdrawals | No | Yes |
Penalty on early withdrawal | Sometimes | Yes |
Required minimum distribution | No | Yes |
Contribution Limit | $7,000 in 2024, plus a catch-up contribution of $1,000 if you are 50 or above | 25% of the salary or $69,000 (2024) |
Which One is Right for You?
For some individuals, a SEP IRA would be a better option than a Roth IRA. For small business owners with fewer employees who want to capitalize on their savings for retirement, SEP is the right choice for these self-employed owners. The tax would be low with higher contribution limits, saving much money.
A Roth IRA is a simple option for everyone who has earned money. Withdrawing earnings doesn't cost any tax, making retirement tax planning quite simple. Roth IRAs allow flexible early withdrawal rules with 10% free, which you can avoid in case of exceptions, like new child adoptions, serious health issues, or other life uncertainty. However, the contribution limits are very low compared to Roth IRAs.
If you want to simplify your income taxes and remain flexible with your savings, a Roth IRA would be the right option. But if you want to boost your retirement savings, a SEP IRA is for you. Keep in mind that you can contribute to both Roth IRAs and SEP IRAs within the same years if you want to invest in both.
The Bottom Line
SEP IRA puts the funding burden on the employer, while Roth IRA requires contributions. The contribution limit in a Roth IRA is low, which may not be the ideal single solution for retirement. But SEP IRA is the right option, especially when your employees are ready to contribute enough funds.
Both retirement plans offer tax-free rollovers compared to other IRAs. At the age of 59.5, both Roth and SEP IRAs allow tax-free earnings distributions. In both IRAs, you can get early distribution of funds in case of emergencies (like major tax bills or medical expenses).
Choosing the best IRA depends on your preferences. If you have earned income that you want to save for retirement, consider a Roth IRA with a low contribution limit. If you are self-employed with other employees who can contribute 25% of their salary, you can opt for a SEP IRA to benefit from a high contribution limit.
