ROTH IRA AND SEP IRA

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There are multiple variations of individual retirement accounts or IRAs, for short. You have probably heard of many different types and may already invest using one of these vehicles.

The names below might ring a bell and fit into the accounts broadly under the IRA. (This information was pulled directly from this source at Investor.gov)

1/ Traditional IRA. The contributions typically are tax-deductible. You pay no taxes on IRA earnings until retirement, when withdrawals are taxed as income.

2/ Roth IRA. The contributions are made with after-tax funds and are not tax-deductible, but earnings and withdrawals are tax-free.

3/ SEP IRA. It allows an employer, typically a small business or self-employed individual, to make retirement plan contributions into a Traditional IRA established in the employee's name.

4/ SIMPLE IRA. Is available to small businesses that do not have any other retirement savings plan. The SIMPLE – which stands for Savings Incentive Match Plan for Employees – IRA allows employer and employee contributions, similar to a 401(k) plan, but with simpler, less costly administration, and lower contribution limits.

Regardless of the specific type, an IRA is basically like a checking/savings account but for investing. Instead of holding funds at a bank and collecting a relatively small stated interest rate, you will hope to earn a higher rate of return through investing in stocks, bonds, etc.

Although each type of IRA is useful for the right person, there are two variations that stick out to me. The Roth IRA and the SEP IRA stand out. What makes each of these unique?

We’ll explore below!

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ROTH IRA

Most people start their investing journey using this version of the IRA. The inherent advantages of the Roth IRA slant in favor of those investors who are relatively young and/or have a low tax rate.

1/ Initial Setup

Generally speaking, opening and funding a Roth IRA will look something like the steps below:

• Determine if you qualify, based on your income and tax status.

• Select a financial institution where you will open and manage your account.

• Open the account and make your initial contribution.

• Choose/purchase investments to hold inside of the account.

• Make ongoing, regular contributions.

This entire process will only require a few clicks. Every online brokerage firm or investment institution will have a webpage with an outline of the entire process, walking you through each step.

Taking the first step is always the most difficult, but the hurdle is not as large as you might imagine.

2/ Contribution Limits

Unlike its Traditional counterpart, the contributions to a Roth IRA are not tax-deductible. There is still an advantage to you as an individual investor though.

Once you reach age 59 ½, you will be able to withdraw funds without paying taxes. Even the total return or growth of your funds can be withdrawn without paying taxes.

Since you paid taxes on your regular income and then deposited funds into your Roth IRA, you can also access your contributions prior to age 59 ½ without paying taxes or penalties. Although it usually makes sense to stay invested, you might make a withdrawal if there is some unforeseen emergency. In any case, it is nice to (legally) avoid paying taxes.

Because of this huge benefit to investors, the government/IRS has created an income cap for Roth IRAs. If you have a great income (measured by Modified Adjusted Gross Income or MAGI), then you may not be able to contribute to a Roth IRA. The income limits for the next couple years are shown below:

• In 2022 for single tax filers then MAGI less than $144,000.

• In 2023 for single tax filers then MAGI less than $153,000.

• In 2022 for married filing jointly tax filers then MAGI less than $214,000.

• In 2023 for married filing jointly tax filers then MAGI less than $228,000.

3/ General Outline

The most important thing to know about the Roth IRA is the access to tax-free growth. For the purpose of summarizing all of the characteristics of this version of the IRA…

• Your contributions are not tax-deductible.

• You will not be required to make contributions every year.

• Your account can be stowed at essentially any financial institution.

• Any contributions must be made before the tax filing deadline. (usually April 15th)

• You can invest your dollars in essentially every public asset class (e.g., stocks and bonds).

• You won’t be subject to required minimum distributions (RMDs). Your money will stay invested and growing throughout your entire life.

4/ Pros and Cons

Sometimes people act like the Roth IRA is God’s gift to investors. It is definitely a great tool, but it may not be perfect for everyone.

Pros

• Tax-free growth is the hallmark of the Roth IRA. It is hugely valuable to investors, especially those with a long time horizon.

• You won’t be subject to RMDs, which allows your investments to continue growing with time (even in retirement).

• With a Roth IRA, you diversify the tax treatment of your retirement assets. You’ll have more control of your income in retirement.

Cons

• The Roth IRA is subject to an income limit. You may not be able to contribute to a Roth IRA and take advantage of tax-free growth as your income grows.

• You won’t receive a tax deduction in the current year. You do typically receive a tax deduction in the current year with the Traditional IRA.

• The maximum contribution is relatively low, so you will likely have to find other ways (e.g., an employer sponsored retirement plan or other individual accounts) to fully fund your retirement.

SEP IRA

Since you are probably not as familiar with this type of account, let’s cover some general background information first.

A Simplified Employee Pension plan, or just “SEP IRA” to keep things short, is like an IRA and an employer sponsored plan combined into one account. Because of its tax treatment and operation, it is incredibly similar to the Traditional IRA.

Because of the advantages a SEP IRA creates for an employer or business owner, it is like an employer sponsored retirement plan.

Although you may be hesitant to believe it, the word “simplified” is included in the name because a SEP IRA is easier to set up and maintain than other employer sponsored retirement plans, like the 401(k) plan.

Since a SEP IRA is also an IRA, you have a high level of control over the investments held within the account. You can invest in essentially every public asset class (e.g., stocks, bonds, REITs, money markets, etc.)

A SEP IRA also works if you are self-employed or have self-employment income. If you ever decide to add other employees in the future, you will be able to do so without nullifying your own SEP IRA.

1/ Initial Setup

According to the IRS, a SEP IRA can be established in three steps:

• Execute a written agreement to provide benefits to all eligible employees.

• Give employees certain information about the agreement.

• Set up an IRA account for each employee.

Most employer sponsored retirement plans provide a benefit to all employees under a single plan. With a SEP IRA, there will be an account for each individual employee.

Once the plan is created, every participant (and don’t forget yourself!) will have his or her own SEP IRA account. The account can be held at a bank or investment broker.

Although the SEP IRA can be offered company-wide, it is especially popular among self-employed solopreneurs or individual business owners. The SEP IRA offers a great deal of flexibility and control while simultaneously being relatively simple to manage.

2/ Contribution Limits

Both Traditional and Roth IRAs have a specific, absolute limit each year. To determine your limit for a SEP IRA, you will have to do some simple math.

Your maximum contribution is based on your income. You can contribute up to 25% of your net business income, with a maximum contribution of $61,000 in 2022. (This amount will be pushed up to $66,000 in 2023.)

Unfortunately, determining your total contribution is not as simple as multiplying your net income by 25%. Before you will be able to determine your maximum contribution, you must first deduct the contribution from your income.

Because of the complexity and high potential for errors (and thus penalties from the IRS), you probably want to work with a CPA to assist with the tax preparation component of contributing to a SEP IRA. This becomes even more vital if there are other employees beyond yourself.

The complexity doesn’t stop there though. After you reduce your income by deducting the actual contribution, you must also reduce that income by one-half of your self-employment tax.

Is it tricky? For sure! The CPA and even a financial advisor can be hugely beneficial in the implementation and/or management of a SEP IRA.

3/ General Outline

In most ways, a SEP IRA is most similar to a Traditional IRA. All of the bullet points below provide additional detail about the SEP IRA, summarizing the most important elements of this retirement savings vehicle.

• A SEP IRA can be created for a sole proprietorship, a partnership, an LLC, or either an S-Corp/C-Corp.

• Any contributions will be tax-deductible in the year taken.

• You are not required to make contributions each year.

• Any contributions must be made before the tax filing deadline. (usually April 15th)

• All investments will grow tax-deferred (i.e., you will pay taxes later).

• There will be required minimum distributions (RMDs) starting at age 72.

4/ Pros and Cons

As with everything, there are pros and cons. The SEP IRA is a powerful tool for business owners to funnel more dollars into the market, yet there are still a few downsides.

Pros

• It is relatively easy to set up and operate a SEP IRA, some of the other options for individual business owners are a bit more complicated and require extra paperwork.

• The maximum contribution ($61,000 in 2022 and $66,000 in 2023) is high. The SEP IRA allows you to funnel lots of dollars into the market.

• Your contributions are tax deductible. You will be able to reduce your gross income by contributing to a SEP IRA.

Cons

• There is no Roth option for SEP IRAs. Your investments will grow on a tax-deferred basis.

• There are no catch-up contributions. For some retirement accounts, you are able to contribute additional dollars after age 50. This isn’t the case for SEP IRAs.

JUST SO YOU KNOW

Every individual has specific needs.

The Roth IRA and the SEP IRA can be great solutions for many people but may not be right for everyone. If you have questions about whether either of these accounts is right for you, do a bit of research on your own and then reach out to a financial advisor.

Each type of IRA has unique advantages. Because of this, each is ideal for a unique individual. Always make sure an investment account is right for you and fits into your specific financial plan.

If you would like to read more about the Roth IRA and SEP IRA, these resources were crucial in creating this article

1/ Roth IRA (from the IRS and from Investopedia)2/ SEP IRA (from the IRS and from Investopedia)

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TL;DR

If you qualify for either a Roth IRA or SEP IRA, it is a great tool for your investing journey.

It requires some level of dedication and commitment to open an account, fund the account, and stay invested in difficult times.

When you complete each of these actions, you take another step on the path to wealth.

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Did you know about the Roth IRA and the SEP IRA? Both accounts can be great tools for the right type of person/investor.

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