Roth IRA vs. SEP if Self-Employed

Your choice of retirement plan depends upon your situation.

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There is no perfect retirement account, even if you're self-employed. While small business owners enjoy a little more flexibility when they determine their retirement options, calculating whether to invest in an Roth individual retirement arrangement or a simplified employee pension plan IRA -- or both -- is a matter of how each fits into your personal retirement plan preferences.

Roth IRA Contribution Basics

Self-employed investors may use a Roth IRA to help fund part of their retirement. The only requirements are that you -- and/or your spouse -- have earned income equal to your contributions, but your adjusted gross income must be under $120,000 if single or $189,000 if married. Rules for Roth contributions are the same for spouses who work or don’t work. If you’re married and file separately, however, spouses who report more than $10,000 in income can’t contribute. Roth IRAs allow only after-tax contributions rather than tax-deductible contributions as for traditional IRAs. As of 2018, single individuals may contribute $5,500 each year, or $6,500 if you’re 50 or older; those amounts double if you file a joint return.

Roth IRA Distribution Basics

Although you pay income taxes on funds you deposit in an Roth IRA, all investment income you receive is virtually tax-free. Because you paid income taxes on the contributions before you made them, distributions from a Roth aren’t subject to income taxes again. As with traditional IRAs, you face a 10 percent penalty if you receive a distribution before you turn 59 1/2 or sooner than five years after you opened your Roth IRA. The IRS allows penalty-free early distributions under some circumstances; these include up to $10,000 to purchase your first home or distributions you take if you become disabled and can't work.

SEP Contribution and Distribution Basics

If you are self-employed and have no other employees or high employee turnover, a SEP IRA may be a good solution for your retirement needs. A SEP allows you to make pretax contributions similar to a traditional IRA, which reduces your taxable income rather than after-tax contributions like a Roth IRA. Another advantage over a Roth IRA is the higher contribution limit. You may contribute as much as 25 percent of your annual income, up to $55,000 cap, in 2018. Because these contributions are made on a pretax basis, however, once you reach retirement age -- at least 59 1/2 -- you pay income tax on all distributions.

SEPs with Employees

Although the SEP contribution limits are much higher than those of Roth IRAs, they come with a major caveat: You have to contribute the same percentage of wages for every eligible employee in your company. Although you may set more lenient requirements, the Internal Revenue Service requires that any employee who is over 21, earned $550 in wages from you during the year and worked at least three of the five prior years, receives the same contribution percentage as you. Thus, SEP IRAs are costly and generally impractical for business owners with large staffs.

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About the Author

Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.

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