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Most people are constantly thinking about their retirement. It’s the time in life where hard work pays off, and relaxation can finally be had. However, there’s more than one road to retirement. There are a number of different accounts that can be used to fund retirement SMEs success story. Depending on an individual’s needs, different accounts are more suitable than others. Two of the most popular retirement accounts available are the SEP IRA vs Roth IRA.
These two retirement accounts really depend on the circumstances of a self-employed individual. Both of them are considered tax-advantaged savings vehicles start using the paystub generator.
Each provides particular benefits. As such, it’s important to understand the differences between the two. There are specific contribution limits to each, as well as limitations to who can use the accounts. Keep reading to learn more about both!
Main Differences Between SEP IRA vs Roth
The main differences between SEP IRA vs Roth are:
- SEP IRA plans allow for higher contributions on an annual basis, whereas Roth IRA plans are capped at $6,000 in contributions each year
- SEP IRA plans are meant for self-employed individuals, or small business owners, whereas Roth IRA plans are for individuals
- SEP IRA account contributions are pre-tax, whereas Roth IRA account contributions are after-tax
- SEP IRA plans have a minimum distribution age of 72, whereas Roth IRA plans do not have a minimum distribution age
- Distributions for SEP IRA plans are subject to federal income tax, whereas with specific criteria being met, Roth IRA plans are not subject to federal income tax
With all of these big differences, it’s easy to see that each account is designed for a different kind of person. Below, all of the details of each account will be reviewed and gone over more comprehensively.
What is a SEP IRA?
A SEP IRA is a retirement plan designed for self-employed individuals and small business owners. The name is actually an acronym, meaning “Simplified Employee Pension.” It works similarly to a 401(k). However, the biggest advantage of a SEP IRA is that it’s far simpler than a 401(k), hence the name.
Unlike a 401(k), there aren’t as many legal or administrative tasks required. These tasks tend to be arduous, to say the least, and require the assistance of a legal professional or legal team to work on them. The simple nature of the SEP IRA is the biggest reason that small business owners lean towards it. It means fewer resources are necessary to run the retirement plan. The same can be said of self-employed individuals.
When considering the contributions of a SEP IRA, it’s important to realize that only employer contributions can be made. This is a precedent set by the IRS. This is a large reason that self-employed individuals lean towards SEP IRA plans. Self-employed individuals are their own bosses, after all.
SEP IRA plans are invested in with pre-tax contributions. This means that the money put into a SEP IRA account is funded before taxes can be taken out of it. Due to this, these contributions likely will be considered a tax deduction on the next year’s tax return. Speak with an online accountant for tax returns regarding the computation.
However, if withdrawals were to be taken on these accounts, regular income taxes would have to be paid on them. These withdrawals can begin to be made at age 59.5 in most cases.
Rules Associated with SEP IRA Contributions
For a person to be able to make contributions to a SEP IRA, there are specific requirements that must be met first. These rules are listed below:
- An individual must be at least 21 years old
- The individual must be a sole proprietor, business owner in a partnership, limited liability company, S corporation or C corporation, or earn income through a means of self-employment
- The individual must have worked for a business or have been self-employed, for at least 3 of the last 5 years
- The individual must have made at least $650 from the employer or by means of self-employment
In addition to these contribution rules, there are also annual contribution limits that are established each year. These limits can vary from year to year, and the amount that an individual can contribute may differ from years prior.
For 2021, small business owners and self-employed individuals can contribute the lesser of the two following figures:
- 25% of the employee’s or individual’s salary
By looking at the two of the above figures, it can be assumed that the maximum amount to be contributed for 2021 is $58,000. It should be noted that the IRS does not allow “catch-up” contributions for SEP IRA plans. This is due to the large amount that can be contributed each year. Because the contributions can be so great, there should not be a need to play “catch up.”
As a business owner, the same salary percentage contributed to an SEP IRA must be contributed to each employee’s plan, as well.
This means that if a business owner contributes 10% annually, the same must be done for each employee. As such, SEP IRA plans are largely recommended to small business owners with very few employees, or to self-employed individuals.
What is a Roth IRA?
On the other hand, there are Roth IRA plans available as well. A Roth IRA is a retirement savings plan that lets individuals make after-tax contributions to the account. That means that all of the money that is contributed has the taxes paid on it ahead of time.
The main advantage to this is the ability to make tax-free withdrawals. These can begin to be made at age 59.5, as long as the Roth IRA has been open for at least 5 years.
The biggest reason to consider a Roth IRA for an individual is if the salary they have is in a higher tax bracket. SEP IRA plan contributions are made pre-tax. As such, the distributions of the funds are subject to the federal income tax. Overall, that means that less of the money will be usable, as it will be taken out at a higher tax rate.
Moving from a SEP IRA plan to a Roth IRA plan can help individuals avoid tax burdens once they’ve reached retirement age. This is the time that the money will be most relied on, and having to pay more taxes on it can affect a person’s overall lifestyle.
Rules Associated with Roth IRA Contributions
Roth IRA contribution rules tend to be much more straightforward than the rules associated with a SEP IRA. The maximum amount of money that a person can contribute to a Roth IRA plan is $6,000. This is true of the year 2021, as well as years past.
However, any individual participating in a Roth IRA retirement savings plan may contribute up to $7,000 in total if they are over the age of 50 and making “catch-up” contributions. The idea behind the “catch-up” contributions is to allow those who haven’t contributed as much to catch up on their savings plans.
It should be mentioned that income level affects how much can be contributed, however. The maximum amount anyone can contribute is $6,000. If an income threshold is exceeded, though, then less may be eligible to be contributed.
In 2021, an individual filing single cannot make more than $140,000 and contribute to a Roth IRA. The figure is based on the modified adjusted gross income or MAGI.
If a person is filing jointly, the income level is raised to $208,000. Individuals can expect to begin phasing out of contribution eligibility when their income level reaches $125,000 or $198,000, depending on the filing status of single or jointly, respectively.
To put it into simple terms, at $125,000, a person filing their income taxes on a single basis will have a reduced contribution level for their Roth IRA.
As the income level increases, the eligible contribution level decreases. As long as a person isn’t making $125,000 or $198,000 in 2021, they can still make the maximum contribution to their Roth IRA plan.
Comparing the Two Retirement Plans So Far
Now that both plans have been covered, it’s time to compare them with one another. When the two plans are looked at side by side, there are a number of differences to compare. First off, the tax status of each plan’s contributions plays a large part in making the choice between the two. A SEP IRA consists of pre-tax contributions, meaning that they will be taxed at a later date.
All contributions made to a Roth IRA are after-tax, meaning that all distributions of the funds will be tax-free at a later date. If an individual is making a large amount of money, it’s more likely that they’ll benefit from a Roth IRA later in life.
The next consideration to be made is the maximum contribution for each on an annual basis. Roth IRAs have a cap at either $6,000 or $7,000 per year. Additionally, if a person is making $125,000 or more per year (on a single filing basis), then the cap is further reduced.
At $140,000, individuals are unable to make any contributions whatsoever. SEP IRA plans have a distinct advantage here. The cap is set much higher and can reach up to $58,000 per year. Again, however, this can be a detriment based on the taxes alone.
The last major thing to consider is the age of withdrawal. With a SEP IRA, the earliest that funds can be withdrawn is at 70.5 years old. There is a minimum withdrawal requirement, with full distribution at age 72. In comparison to a Roth IRA, this is a lot later in life.
Roth IRA plans allow individuals to begin making tax-free withdrawals at age 59.5. If access to money is important, then the Roth IRA provides more flexibility. It can even act as an effective emergency fund if push comes to shove.
Breaking it Down
Pros of a SEP IRA
- Larger contributions can be made annually
- Contributions are tax-deductible
- Legally simple, making it easy to use for small business owners and self-employed individuals
- Flexibility in contributions each year
Cons of a SEP IRA
- Will be subject to federal income tax upon distribution
- Funds cannot be distributed until 70.5 years of age
Pros of a Roth IRA
- After-tax contributions, meaning tax-free withdrawals and distribution
- Earlier distribution age, beginning at 59.5
- Easy to manage contributions, with no financial irregularities from year to year
Cons of a Roth IRA
- Income thresholds determine how much can be contributed
- Lower contribution cap, being at $6,000 for most, or $7,000 for individuals over 50 making “catch-up” contributions
Answer: At this point in time, there are no restrictions on whether or not an individual can have more than one retirement savings plan. The most important thing to do is check for eligibility for both. As long as an individual is eligible and can make contributions in each, they can have both a SEP IRA and a Roth IRA plan.
In fact, both can be invested in while still making contributions to a 401(k). Say a person has a regular job that provides a 401(k), and they’re also self-employed through a side business with a SEP IRA.
These two don’t interfere with one another whatsoever. Should they max out their contributions for both plans, they can also open a Roth IRA, as long as they’re eligible.
One thing to consider is the amount of income being made. If a person has a 401(k) and a SEP IRA, they may be making too much money to open a Roth IRA with the income limit. If the income limit hasn’t been met, then a Roth IRA can be opened.
If the income limit is being crested, it’s worth taking the time to review the SEP IRA contributions being made. These are tax-deductible and can reduce an individual’s gross income, which may make them eligible for the Roth IRA after all is said and done.
Answer: Most financial institutions, like banks and investment companies, offer Roth IRA plans. Shopping around for one is easy, and many offer competitive rates to attract customers.
Some will invest contributions in mutual funds and other securities, increasing the amount of money to be made in the long run. Because a Roth IRA is set up on an individual basis, they are fairly easy to set up once an appropriate one has been found.
SEP IRA plans are also available through most financial institutions and are similar in nature to Roth IRA products.
However, it is important to note that SEP IRAs for employers must follow different guidelines than those for self-employed individuals. For an employer looking to establish a SEP IRA plan for their business and employees, they’ll need:
• To create a formal written agreement using IRS Form 5305-SEP, or something similar from a SEP IRA provider
• To provide the form to their employees eligible for making contributions to the SEP IRA
• To establish individual accounts for all eligible employees that contributions will be made for
For employers, the documentation surrounding a SEP IRA plan is a must. All information must be kept track of for financial and legal purposes.
Answer: When it comes down to it, each plan benefits a different set of people. For those who are looking to fund a retirement plan quickly, a SEP IRA may be the best option available. However, a person must be a small business owner or self-employed to be eligible for a SEP IRA.
On the other hand, a Roth IRA is a plan that works for most people, so long as it’s started early enough. The plan itself has severe limitations in terms of contributions, especially when compared to a SEP IRA.
As such, these are the plans that should be used from an earlier age. Otherwise, it’s impossible to catch up, even with “catch-up” contributions.
SEP IRA vs Roth Explained: The Bottom Line
No matter which retirement plan a person is using, it all comes down to the same thing: saving for a future is important. Retirement plans are one of the best ways that anyone can make sure that they’ve put away enough money to live comfortably during retirement.
For the most part, SEP IRAs are best used by business owners with very small businesses and limited employees. They’re also great for the self-employed. These plans allow for higher contributions but require that employers match these contributions for their employees. On the other hand, Roth IRAs work well for most individuals, granted that they’re started soon enough.
For more information like this, be sure to check out the other articles available on Wallet on Fire!