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A SEP-IRA and a Roth IRA are two types of retirement accounts. While they share a common goal of helping people invest for retirement in a tax-advantaged manner, there are several key differences and advantages to each one. Here's a comparison of these two retirement accounts, along with how to determine which is the best choice for you.
About these two types of retirement accounts
Before we compare the advantages of these two types of retirement accounts, it's important to know some of the basics of each one.
A Roth IRA is a type of retirement savings account that allows people to save money on an after-tax basis, meaning that there isn't a tax deduction for Roth contributions. However, all qualified withdrawals are 100% tax-free. Currently, the contribution limit is $5,500 for the 2015 and 2016 tax years, with an additional $1,000 catch-up contribution for savers over 50.
Anyone who wants to can contribute to a Roth IRA, as long as their adjusted gross income is less than the IRS's limit -- currently $194,000 for married filers and $132,000 for singles, although AGI less than the limit but above $184,000 (married) or $117,000 (single) qualify for a reduced contribution amount.
A SEP-IRA, which stands for "simplified employee pension" is designed for small business owners and self-employed individuals. In other words, not everyone is eligible for a SEP-IRA, since employer contributions are the only type allowed. SEP contributions are made on a pre-tax basis, which means that they may be deductible on your tax return.
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Both accounts are tax-advantaged ways to save for retirement -- unlike with a standard brokerage account; you won't have to pay dividend or capital gains each year on your investments.
Advantages of a SEP-IRA over a Roth IRA
A SEP-IRA is designed for business owners and self-employed people who don't have access to a 401(k) or other employer-sponsored retirement account, so it has benefits designed to replace those of an employer retirement plan:
- High contribution limits: For the 2015 and 2016 tax years, employers and self-employed individuals can contribute up to 25% of the employee's compensation or $53,000, whichever is less.There is no additional catch-up contribution allowance for those over 50.
- Tax deduction: Since contributions to a SEP are made on a pre-tax basis, you can get a nice tax deduction. For example, if you save $10,000 in a SEP-IRA in 2016 and are in the 25% tax bracket, it can save you $2,500 on this year's income taxes.
Advantages of a Roth IRA over a SEP-IRA
Although a SEP-IRA does have some appealing qualities, there are some reasons you may want to consider a Roth IRA as well. Just to name a few of the biggest advantages:
- Tax-free withdrawals: Contributing to a Roth IRA allows you to "lock in" your current tax rate. In other words, if you're in a higher tax bracket when you retire, you won't have to pay a dime in taxes on the money in your Roth IRA.
- Flexibility: Since you've already paid taxes on your contributions, you are free to withdraw them (but not any investment gains) at any time without an early withdrawal penalty. For this reason, Roth IRAs can be great ways to build up an emergency fund, as well as for retirement savings.
- No RMDs: Unlike pre-tax accounts like SEP-IRAs, Roth IRAs have no required minimum distributions (RMDs) after you turn 70 1/2.
It depends what features are important to you
The right account for you depends on which advantages are most applicable to your situation. For example, if you want the ability to contribute more than $5,500 per year, an SEP could be the answer. On the other hand, if you want the option of withdrawing your money early if you want, a Roth could be the better choice.
Of course, there's nothing wrong with opening both types of accounts in order to take advantage of all of the benefits of each (assuming you qualify for both). And there are a few more types of retirement accounts you can consider. The point is that before you make a decision, it's important to weight the pros and cons of all of your options.
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