Roth IRA vs. SEP if Self-Employed

by Herb Kirchhoff

If you are self-employed, you have several retirement plan options to choose from. Two popular options are the tax-deferred Simplified Employee Pension individual retirement account (SEP-IRA) and the after-tax Roth IRA. Each plan offers certain advantages, but comes with accompanying drawbacks. Two major considerations are how much you plan to set aside for retirement and whether you prefer to pay taxes on your retirement savings now or when you retire.

Tax Difference

The SEP-IRA allows you to deduct contributions from your income, and put more aside for retirement than does a Roth IRA. The downside is that retirement distributions will be subject to income taxes, and early withdrawals will not only be taxed, but also penalized. The Roth IRA will provide you with tax-free income at retirement, and offers more liberal early withdrawal exceptions. However, there are limits on income and contributions, and you can’t deduct Roth IRA contributions from your income.

SEP-IRA Particulars

If self-employed, you can open a SEP-IRA by filing a SEP agreement with the Internal Revenue Service. The IRS has a standard form and process for establishing a SEP-IRA, and you can open a SEP-IRA with most financial institutions. You can contribute 20 percent of your income to a SEP-IRA, up to a maximum contribution of $49,000, and deduct the contribution from your taxable income.

Larger Contribution

A SEP-IRA allows a much higher contribution limit than a Roth IRA, and there is no income ceiling that limits your ability to make contributions. Taxes on earnings are deferred. At retirement, your SEP withdrawals will be taxed according to your tax bracket, and you must start taking withdrawals by age 70 1/2. If you make an early withdrawal, which is any withdrawal before you are age 59 1/2, you will not only pay income tax, but also a 10 percent penalty tax on the amount you take out.

Roth IRA Basics

As a self-employed person, you can open a Roth IRA at most financial institutions simply by filling out a few forms. You can contribute up to $5,000 per year ($6,000 annually if you are over age 50). But if you earn more than $105,000 per year, your Roth contribution limit will be reduced. Your contribution limit drops between $105,000 and $120,000. If you earn more than $120,000, you can’t make a contribution to a Roth account.

Not Deductible

Unlike the-deductible contributions you get with the Sep-IRA, a Roth IRA contribution can’t be deducted from your income, but earnings accumulate tax free. At retirement, your Roth withdrawals will be free of tax, and there is no mandatory age to start making Roth withdrawals. If you make withdrawals before age 59 1/2, you can withdraw the money you contributed without tax or penalty. But if you also withdraw earnings before age 59 1/2, you will owe income tax and a 10 percent penalty tax on the withdrawn earnings.

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