There are a variety of Individual Retirement Accounts (IRAs) in the investment landscape today. Here’s a breakdown of two of the less traditional types, the Simplified Employee Pension (SEP) IRA and the Roth IRA.
- While traditional IRAs remain the most popular type of individual retirement account, there are alternatives.
- A SEP IRA is a retirement savings plan set up by employers, including the self-employed, to benefit their employees and themselves who are low cost and have higher contribution limits.
- A Roth IRA uses after-tax contributions which then become tax-free, but have a contribution limit ($6,000 for 2022 and $6,500 for 2023) and are subject to income eligibility limits.
A Simplified Employee Retirement (SEP) IRA is established and funded by a business (including a sole proprietorship) and has the following criteria or components:
- It must be established and funded by the employer’s tax return deadline, including extensions.
- The contribution limit is 25% of compensation or $61,000 for 2022 ($66,000 for 2023), whichever is less. For a sole proprietor, the contribution limit is 20% of the sole owner’s adjusted net business income.
- The contribution within the limits is deductible in the employer’s tax return.
- Account earnings grow on a tax-deferred basis.
- Distributions are treated as ordinary income and are subject to income tax and early withdrawal penalties if you are under the age of 59½ when the withdrawal is made, unless you are entitled to an exception.
SEP Accounts: Jessica Perez
A Roth IRA is set up and funded by the individual taxpayer using after-tax dollars and grows tax-free. It has the following criteria or components:
- Must be established and funded by the individual taxpayer’s tax return deadline (usually April 15), extensions excluded.
- The contribution limit for 2022 is the lesser of 100% of compensation or $6,000 and $7,000 if you are 50 or older by the end of the year for which contributions are made. For 2023, both limits increase to $6,500 and $7,500, respectively.
- Contributions are not deductible.
- Earnings grow on a tax-free basis (certain rules apply).
- Qualifying distributions are exempt from taxes and penalties.
If you finance a SEP IRA and then convert those assets into a Roth IRA, the converted amount will be treated as ordinary income and subject to income tax for the year you convert.
To contribute to a Roth IRA, you must earn less than $144,000 annually as a single filer in 2022 (increasing to $153,000 in 2023) or $214,000 as a joint marriage ($228,000 in 2023).
The bottom line
Choosing a retirement plan that can maximize your benefits is essential. Here are some additional points to consider:
- Choose the right type of plan for your business (including a sole proprietorship): When you’re trying to choose the best plan for your business, other options to consider include SIMPLE IRAs or qualified plans like profit sharing, cashback, and the 401(k) plan.
- Choosing the right type of IRAIndividual owners who make an employer contribution to a SEP IRA can also make an individual contribution to a Roth or traditional IRA.
In general, SEP IRAs and Roth IRAs do not replace each other, as they are two different types of retirement plans. An individual may be able to participate in both if he meets the eligibility requirements.