There are many benefits that come with being self-employed, but one of the potential downsides is that employees will need to figure out their own retirement savings strategy. By forgoing traditional employment—which might come with a retirement plan, such as a 401(k) or 403(b), and even matching employer contributions—self-employed individuals must independently research, open, and fund the retirement savings account that works best for them.
Two possible retirement account options include a SEP IRA and a Roth IRA, both of which offer tax advantages to eligible future retirees. But which is better for self-employed individuals, a SEP IRA or a Roth IRA? Here’s a look at how they compare.
What is a SEP IRA?
A Simplified Employee Pension (SEP) plan is a retirement option available to employers of any size—even self-employed individuals. These plans allow small business owners to set up and contribute to a traditional IRA (individual retirement account) for each employee in their company, without the typical startup costs and maintenance expenses involved with more complex plans, such as a 401(k).
If an employer decides to offer a SEP plan to even a single employee (including themselves), they must offer it to all eligible employees. Each employee is given their own SEP IRA account, where the company makes contributions on their behalf. Employees own those funds entirely from the very beginning, as well—employers are not allowed to require that the funds vest over time.
Employers must contribute an equal amount by percentage to every eligible employee’s plan, up to a maximum of 25% of each person’s employment income or $61,000 annually (for 2022), whichever is less. Unlike with traditional IRAs, however, employees age 50 or older cannot make catch-up contributions into their SEP IRA plan. Employers may adjust the percentage contributed each year.
What is a Roth IRA?
A Roth IRA is another type of individual retirement account, aimed at individuals who meet certain income limits. These savings vehicles enable employees to contribute after-tax dollars to an account where they grow tax-free until retirement. When the time comes to withdraw funds (as soon as age 59 ½), both the original contributions and any growth over the years can be withdrawn without taxes or penalties.
In 2022, eligible individuals can contribute up to $6,000 into their Roth IRA account. If they are age 50 or older, an additional $1,000 catch-up contribution is allowed.
Roth IRAs are not tied to an employer. Eligibility to contribute—and the maximum allowed—is determined by the individual’s income.
For 2022, individuals who want to contribute to a Roth IRA must earn less than:
- $204,000 for married filing jointly or qualified widow(er)
- $129,000 for single, head of household, or select married filing separately (those who didn’t live with their spouse at any point during the year)
- $10,000 for married filing separately (who did live with their spouse at any point in the year)
Individuals who earn below this limit are eligible to contribute, but may not be able to contribute the maximum, as phase-out limits also apply.
A Roth IRA can be opened with any number of different financial institutions, including banks, credit unions, and brokerages. When it comes to selecting a Roth IRA, self-employed individuals can select the account, institution, and specific investment options that suit them best.
SEP vs. Roth IRA: what are the main differences?
There are some very important differences to note when it comes to choosing a SEP IRA vs a Roth IRA for self-employed retirement planning.
For starters, SEP IRAs allow for much larger annual contributions than Roth IRAs. In fact, depending on income, one could set aside 10 times as much in a SEP IRA each year, compared to a Roth. Of course, if there are other employees involved in the company, they would be required to get the same percentage of SEP IRA contributions compared to their earnings.
The accounts also offer different tax advantages: SEP IRA contributions are tax-deductible to the business each year, but withdrawals are taxed as ordinary income in retirement. Roth IRA contributions are made with after-tax dollars today, but continue to grow tax-free and are withdrawn without additional taxes in retirement.
Benefits and limitations of SEP IRAs
SEP IRAs allow small business owners to reduce their taxable income. “Self-employed people have to pay self-employment tax on their income,” explains Titan retirement specialist Eddie Lopez. “That’s why lowering your ordinary income with SEP IRA contributions can be attractive.”
But SEP plans come with limitations—especially for business owners who have employees.
Benefits of SEP IRAs
- Employers are not required to contribute every year.
- Employees are 100% vested in the funds from day one.
- Small businesses can deduct their SEP IRA contributions at tax time.
- SEP IRAs allow for a higher annual contribution limit than other IRAs.
- Available to high earners.
Limitations of SEP IRAs
- Contributions are maxed out at $61,000 per year (2022) or 25% of the employee’s pay, whichever is less.
- Loans are not allowed.
- Withdrawals before age 59 ½ are subject to both taxes and potential penalties, unless the withdrawal is for an exempt purpose.
- Catch-up contributions are not allowed.
- All employees must be offered the same SEP IRA contribution amount (by percentage of earnings).
- Withdrawals in retirement are taxed.
Alternative to SEP IRAs for self-employed people
Self-employed individuals also have the option of a 401(k)-style retirement savings account, in the form of a Solo 401(k). These one-participant retirement accounts are available to individual business owners (and their spouses), and allow self-employed individuals to make contributions both as an employer and an employee, up to an annual maximum of $61,000 in 2022 ($67,500 for those age 50 and older).
Benefits and limitations of Roth IRAs
Roth IRAs allow eligible individuals to save for retirement with post-tax contributions today, but which grows tax-free until retirement. “Once you turn 59½,” explains Lopez, “The IRS can touch a dime.”
But not everyone can contribute to a Roth; eligibility is based on income.
Benefits of Roth IRAs
- Allow for individual retirement savings without requiring contributions for anyone else.
- No RMDs for the original account owner, regardless of age.
- Contributions and growth can later be withdrawn in retirement without taxes or penalties.
Limitations of Roth IRAs
- Low annual maximum of just $6,000 ($7,000 for 50 and older) in 2022.
- Depending on income, allowed contributions can be phased out or prohibited altogether.
- No tax advantages at the time of contribution.
Alternatives to Roth IRAs for any saver
One alternative to the Roth IRA that is available to nearly all individuals is a traditional IRA. These retirement savings accounts have the same contribution limits as a Roth, but offer tax deductions in the year that contributions are made. For business owners, saving into a traditional IRA is free of the requirement to offer equal contributions for any other eligible employees.
How to open an SEP IRA
Self-employed business owners interested in opening a SEP IRA will first need to select the financial institution that will hold the IRA accounts for each employee (even if it’s just one). If additional employees will be involved, an agreement outlining the terms of the SEP-IRA offering should be provided to each employee.
Each employee will receive his or her own SEP IRA account, which the company will fund at its discretion. Employees are responsible for how that money will be invested; however, they are 100% vested in any contributed funds right away.
How to open a Roth IRA
A Roth IRA can be opened at any number of financial institutions, such as banks, credit unions, and even investment brokerages. As long as the self-employed individual qualifies for a Roth (based on their income) a new account can be opened and funded with an after-tax contributions.
Once the right financial institution is selected, it’s a matter of completing the process to open a new account. This usually means providing proof of identity, proof of employment, and information on the bank that will be used to fund the account.
The account owner can then choose how they want to invest their Roth IRA funds, either by selecting individual investments, opting for a target-date fund, or curating a portfolio allocation based on personalized goals.
Can one open both a Roth IRA and a SEP IRA?
Self-employed business owners can have both a Roth IRA and a SEP IRA as part of their overall retirement savings plan, as long as their income falls within the permitted threshold for a Roth.
The business owner’s company would fund the SEP IRA, whereas the business owner would fund the Roth personally. For this reason, the contributions made to a SEP IRA will not affect the maximum contributions that are allowed to be made into a Roth IRA. Conversely, if a business owner has both a Roth and a traditional IRA, their limit for the year includes contributions into both accounts.
The bottom line
Saving for retirement can involve a multi-faceted approach, particularly for small business owners and self-employed individuals. Two beneficial retirement savings accounts include the SEP-IRA and the Roth IRA, both of which utilize individual retirement accounts (IRA) to save for the future. Each offers its own limits, requirements, and benefits, so choosing the right one is a very personalized decision.