Can a Simplified Employee Pension (SEP) Be Converted to a Roth IRA?

Yes, but you’ll be subject to taxes like any Roth conversion

You can convert a Simplified Employee Pension (SEP), or SEP individual retirement account (IRA), to a Roth IRA. A SEP IRA is just a traditional IRA that an employer or a self-employed person can establish, and it operates by the same rules. Like any Roth IRA conversion, you’ll need to follow Internal Revenue Service (IRS) rules and will owe taxes on the amount converted in the year when it takes place. In this article, we cover some of the basics of a conversion as well as some of the key considerations if you're thinking of making the switch.

Key Takeaways

  • A Simplified Employee Pension individual retirement account is a traditional IRA that is designed for small business owners and the self-employed.
  • You can convert your SEP account to a Roth IRA the same way you would with any other IRA.
  • You will owe income taxes for that tax year on the entire balance since you're rolling over funds from an account funded with after-tax dollars to one that has an after-tax benefit.
  • Your IRA trustee can see the conversion process for you from beginning to end.
  • If you receive a check and want to fund the account yourself, you must do so within 60 days lest it count as a distribution.

Understanding the SEP IRA

Like a traditional IRA, you can open a SEP IRA at just about any bank or financial institution. And there are a variety of investment options available to fund your account. Earnings grow on a tax-free basis, which makes the withdrawals taxable as ordinary income when you retire.

A variation of the traditional IRA, the SEP IRA is designed for small employers, including those who are self-employed. It allows employers to make tax-deductible contributions on behalf of eligible employees. Unlike a traditional IRA, an employee cannot contribute. Instead, the employer may contribute to an employee’s fund as well as to their own. If you are self-employed, you count as both the employer and the employee, which means you're able to fund your own account.

This IRA is intended to be easy to set up for flexible use. An employer can decide at the end of the year whether to make a contribution and how much. However, the employer must contribute not only to their own fund but also to any eligible employees’ funds. SEP IRAs also have higher annual contribution limits than traditional and Roth IRAs.

You must have earned income or what the IRS calls taxable compensation to contribute to a Roth IRA.

Converting a SEP IRA to a Roth IRA

Making the conversion from a SEP IRA to a Roth account isn't as difficult as you may think. But there are a few things you may want to think about before you make the switch. We've highlighted some of the key considerations of a SEP IRA below, including taxes, distributions, and early withdrawal penalties.

Taxes Owed Upon Conversion

A traditional IRA is named as such to distinguish it from the Roth IRA. This type of account has one main difference from a traditional IRA: The taxes are paid upfront. This rule also applies to a SEP IRA. That means you contribute after-tax earnings and get no immediate tax deduction. But you never owe taxes on that money again, meaning there are no taxes on the principal, earnings over the years, or withdrawals after the age of 59½.

But keep in mind that when you convert a traditional or SEP IRA to a Roth IRA, you owe taxes on the balance in that tax year. That's because the money you contributed to the SEP was done with after-tax dollars. When you roll the money over to a Roth account, it goes to an after-tax vehicle. This means you have to pay taxes on the contribution amount.

How much tax you pay will depend on your tax bracket and how much money you convert. It is taxed as ordinary income. So if the amount of your annual income is higher, you'll have to pay a higher tax rate on the rollover amount.

Distributions

Another benefit of the Roth IRA is that you will not be required to make annual withdrawals as with a traditional IRA. These withdrawals are called required minimum distributions (RMDs). They are designed so individuals don't use their retirement accounts as a way to save their money to use later and avoid paying taxes.

You can begin making withdrawals or RMDs from your retirement accounts when you're 72. RMDs must start by April 1 after the year you turn 72. The age threshold for taking RMDs was changed in 2020. Prior to this, the minimum age to take withdrawals was 70½.

To determine the amount, the fair market value (FMV) of your account at the end of the prior year is divided by the life expectancy or total distribution period. The amount of individual RMDs is based on a calculation that's usually done by your custodian or trustee, or you can use a worksheet provided by the IRS.

Early-Withdrawal Penalties

Any time you make a withdrawal from any retirement account before you're allowed to do so, including a SEP IRA, the IRS imposes an early withdrawal penalty. The penalty is 10% on any amount withdrawn before the age of 59½. Keep in mind, though, that this is on top of the taxes you may incur from making a withdrawal.

There are exceptions to the early-withdrawal rule. For instance, anyone who takes money from their account(s) for qualified tuition expenses for themselves, their spouse, or a dependent is exempt from any tax-related penalties. Additionally, qualified taxpayers can withdraw up to $10,000 from their IRA accounts to purchase their first homes.

Converting a SEP IRA to a Roth IRA can be a sound retirement planning strategy if you can afford to pay the taxes now instead of later in retirement. This is especially true if you expect to be in a higher tax bracket after you retire.

How to Convert a SEP to a Roth IRA

Contact the financial institution that manages your SEP IRA to convert to a Roth IRA. In IRS-speak, this is the trustee for the account. You can rollover the money into a Roth account at that institution or somewhere else if you choose.

The most straightforward way to execute a Roth conversion is to request that the trustee transfer the funds to the Roth IRA directly. This is what the IRS calls a trustee-to-trustee transfer, since the financial institution holding your SEP IRA makes the payment directly from that IRA to the financial institution holding the new Roth IRA.

It’s more complicated to have the funds paid directly to you. This means a check is made out to your name. If you’ve been paid directly and don’t redeposit the check into the Roth IRA within 60 days, it counts as a distribution, and you’ll pay taxes—plus an early withdrawal penalty of 10%, if you’re under the age of 59½.

Should I Convert My SEP IRA to a Roth IRA?

That depends. Converting your SEP IRA to a Roth account triggers a taxable event. That's because you're rolling an account that was funded by after-tax dollars to an account that comes with tax benefit during retirement as the distributions don't count as income. Having said that, rolling a SEP over makes a lot more sense if you're able to afford the associated taxes before you retire. This is especially true if you believe that you'll be in a higher tax bracket during retirement.

What Is a Roth Individual Retirement Account Conversion?

A Roth individual retirement account (IRA) conversion takes place when retirement funds from either a traditional-type IRA, including a Simplified Employee Plan (SEP) IRA, or a 401(k) are transferred into a Roth account. You’ll pay tax on the money converted, but withdrawals from the Roth IRA are tax free when you reach age 59½.

How Much Is the Early Withdrawal Penalty?

The early withdrawal penalty for Roth and traditional IRAs is 10% of the amount that you withdraw before age 59½, and you will also owe income tax. You can withdraw contributions (but not earnings) at any time from a Roth IRA, without being subject to the penalty or tax.

How Much Can I Contribute to My Roth IRA?

The contribution limit for a Roth (and traditional) IRA is $6,000 in 2022, the same as 2021. If you are age 50 or older, you can contribute an additional catch-up contribution of $1,000.

The Bottom Line

It is possible to convert a SEP IRA to a Roth IRA. And it's fairly easy to do so—just contact your account custodian or trustee and let them know your intention to do so. If you're wondering, the rules are the same as with any Roth conversion. But should you make the switch? That depends. It may make sense to do so if you expect to be in a higher tax bracket when you retire and want to benefit from the tax-free withdrawals that Roth IRAs provide. You also won’t be subject to RMDs.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Internal Revenue Service. “Publication 560 (2021), Retirement Plans for Small Business.”

  2. Internal Revenue Service. “Topic No. 451 Individual Retirement Arrangements (IRAs).”

  3. Internal Revenue Service. “Publication 590-B (2021), Distributions from Individual Retirement Arrangements (IRAs).”

  4. Internal Revenue Service. “Retirement Topics — Required Minimum Distributions (RMDs).”

  5. Internal Revenue Service. "Retirement Plan and IRA Required Minimum Distributions FAQs."

  6. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions."

  7. Internal Revenue Service. “Rollovers of Retirement Plan and IRA Distributions.”

  8. Internal Revenue Service. "Retirement Topics - IRA Contribution Limits."

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