Features and Benefits of Sep IRAs and Roth IRAs

There are a variety of individual retirement accounts (IRAs) on the investment landscape these days. Here’s a breakdown of two of the less-traditional types, the Simplified Employee Pension (SEP) IRA and the Roth IRA.

SEP IRA

A simplified employee pension (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 filing 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 proprietor’s adjusted net business income.
• The contribution within the limits is deductible on the employer’s business 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 age 59½ when the withdrawal is made unless you are eligible for an exception.

Roth IRA

A Roth IRA is established and funded by the individual taxpayer using after-tax dollars and grows tax-exempt. It has the following criteria or components:

1. It must be established and funded by individual taxpayer’s tax filing deadline (usually April 15th), extensions not included.
2. The contribution limit for 2022 is the lesser of 100% of compensation or $6,000 and $7,000 if you are at least age 50 by the end of the year for which the contribution is being made. For 2023, both limits increase to $6,500 and $7,500 respectively.
3. Contributions are not deductible.
4. Earnings grow on a tax-free basis (certain rules apply).
5. Qualified distributions are tax- and penalty-free.

If you fund a SEP IRA and then convert those assets to a Roth IRA, the converted amount will be treated as ordinary income and subjected to income tax for the year you made the conversion.

The Bottom Line

Choosing a retirement plan that can maximize your benefits is essential. Here are some additional points to consider:

• Choosing the right plan type for your business (including a sole proprietorship): When you are trying to choose the best plan for your business, other options to consider include SIMPLE IRAs or qualified plans such as profit sharing, money purchase, and 401(k) plan.
• Choosing the right type of IRA: Sole proprietors making an employer contribution to a SEP IRA may also make an individual participant contribution to a Roth or traditional IRA.

Generally, SEP IRAs and Roth IRAs are not substituted for each other, as they are two different types of retirement plans. An individual may be able to participate in both if they meet the eligibility requirements.