Traditional vs. Roth vs. SEP IRA: An Overview
Officially, an IRA is defined as an individual retirement arrangement by the U.S. Internal Revenue Service (IRS). Generally, people refer to it as an individual retirement account. An IRA offers investors a tax-deferred way to build the value of their investments during their working years.
Traditional IRAs, Roth IRAs, and SEP IRAs are three types of individual retirement accounts. In some ways, they're similar. Yet, there are some key differences in how they work, which can make one type better than another, depending on your goals and tax situation.
This article provides the basics for all three IRAs to help investors get started on their retirement savings journeys.
- Traditional, Roth, and SEP IRAs can serve different purposes for different people.
- A traditional IRA offers you a tax deduction when you make a contribution.
- A Roth IRA doesn't offer tax-deductible contributions, but all qualified distributions are tax-free.
- If you have self-employment income, a SEP IRA will allow you to contribute more for retirement than a traditional IRA or a Roth.
- Even if you have a workplace retirement plan, you may also contribute to an individual retirement account, such as a traditional or Roth IRA.
A traditional IRA allows you to contribute pre-tax income to investments of your choice. Your money then grows tax deferred until you withdraw it in retirement. Many workers also roll the funds from their 401(k) or other company retirement plans into traditional IRAs when they retire or change employers.
You can take a tax deduction for your contributions to a traditional IRA, provided your income falls below certain limits and you (and your spouse) meet the other eligibility requirements (such as having no workplace retirement plan). That means that you'll reduce your taxable income by the amount that you can contribute.
When you withdraw money from the account, typically in retirement, it will be taxed as ordinary income (when you may be in a lower tax bracket). Bear in mind that you can access your funds at any time, but you'll face financial penalties for doing so before age 59½.
The money in a traditional IRA can't grow tax-deferred forever. The Setting Every Community Up for Retirement Enhancement Act (SECURE Act) in December 2019 raised the maximum age at which you must begin taking the IRS's required minimum distributions (RMD) each year to 72 (from 70 1/2).
SECURE 2.0 in December 2022, increased the age further. Now, if you were born between 1951 and 1959, you must begin taking RMDs at 73. If you were born in 1960 or after, you must begin at 75. The amount you must take is determined according to a formula based on your yearly account balance and a life-expectancy factor determined by the IRS.
Individuals may contribute to an IRA and a SEP, especially if they are self-employed or have self-employment income and meet the stated income guidelines.
Traditional IRA contributions are capped at $6,500 a year for 2023, with the option of an additional $1,000 catch-up contribution if you're 50 or older, for a total of $7,500.
If you don't have a workplace-sponsored retirement plan, or if you think you'll be in a lower tax bracket after you retire than the one you're in now, a traditional IRA can be a good savings option.
The Roth IRA was introduced in 1997.
However, contributions are not tax deductible. With Roth IRAs, investors get their tax break on the back end. They pay no taxes on money withdrawn from their accounts.
For that reason, Roth IRAs are an attractive option for working people who expect to be in a higher tax bracket after they retire than they were in while working.
A SEP IRA offers no catch-up contributions for people aged 50 and over.
Another positive feature is that, unlike traditional IRAs, Roths aren't subject to required minimum distributions during your lifetime. So, if you don't need the money in your Roth IRA for living expenses, it can pass to your heirs when the time comes.
Roth IRAs have their own eligibility requirements. If your income exceeds a certain level, you won't be able to contribute to one.
Married Couples Filing Jointly
For 2023 contributions:
- If you make less than $218,000, you can contribute up to the allowed limit.
- If you make $218,000 but less than $228,000, your allowed contribution will be reduced.
- If you make $228,000 or more, you may not contribute to a Roth IRA.
For Single Filers and Heads of Household
For 2023 contributions:
- If you make less than $138,000, you can contribute up to the allowed limit.
- If you make $138,000 but less than $153,000, your allowed contribution will be reduced.
- If you make $153,000 or more, you may not contribute to a Roth IRA.
To determine how much a contribution must be reduced (if your annual income is over the thresholds as mentioned earlier), the IRS provides this formula, which is detailed in Publication 590-A, available from the IRS website:
- Determine your modified adjusted gross income (MAGI).
- Subtract the following from your MAGI:
- $218,000 (2023) if filing a joint return or as a qualifying widow(er), or
- $0 if married filing a separate return, and you lived with your spouse at any time during the year, or
- $138,000 (2023) for all other individuals
- Divide the result by $15,000 (use $10,000 if you're filing a joint return, are a qualifying widow(er), or are married filing a separate return and you lived with your spouse at any time during the year).
- Multiply this result by the maximum contribution limit (in 2023, $6,500 or $7,500 if you're 50 or older).
- Subtract the result from the maximum contribution limit. This is your reduced contribution limit.
For example, if you are married filing jointly, over 50 (a limit of $7,500), and have a MAGI of $224,000, your reduction calculation would look like this (in 2023):
- $224,000 - $218,000 = $6,000
- $6,000 / $10,000 = 0.6
- 0.6 x $7,500 = $4,500
- $7,500 - $4,500 = $3,000
So, your contribution limit with these criteria is $3,000.
A simplified employee pension (SEP) IRA is a type of individual retirement account that a business owner can open. The SEP IRA allows small employers to provide a basic retirement plan for themselves and their employees, if any, without the cost and complexity of a 401(k) or similar plan. In addition, employers can take a tax deduction for their contributions, much like a traditional IRA.
An advantage of the SEP IRA, if you have self-employment income to fund it, is that it has much higher contribution limits than a traditional or Roth IRA. You can contribute up to 25% of your compensation or $66,000 for 2023, whichever is less.
As with a traditional IRA, withdrawals from a SEP IRA are taxed as ordinary income in retirement, and required minimum distribution rules apply.
The table below outlines the key differences between the three retirement accounts.
|Traditional IRA||Roth IRA||SEP IRA|
|Tax break||On pre-tax income||When withdrawn||On pre-tax income|
|Annual contribution amounts||$6,500 (2023) plus an extra $1,000 if age 50 or above||$6,500 (2023) plus an extra $1,000 if age 50 or above||The lesser of 25% of compensation or $66,000 (2023)|
|Taxation||Withdrawals taxed as ordinary income||Taxed as ordinary income before contributed||Withdrawals taxed as ordinary income|
|Deduction eligibility||Allowed in full if no workplace retirement plan; otherwise, reduced||Allowed in full if annual income is less than certain thresholds; otherwise reduced||Allowed in full up to contribution limit|
|Used by||Individuals with taxable compensation||Individuals with taxable compensation||Business owners who are self- employed and have taxable compensation|
"With a traditional IRA, you contribute pre-tax money that reduces your taxable income. When you withdraw the money in retirement, it is taxed as ordinary income, meaning your tax obligation was deferred.
With a Roth IRA, you contribute post-tax money. Contributions do not offer any up-front tax break. Instead, withdrawals are tax-free in retirement.
A SEP is set up by an employer—as well as a self-employed person—and permits the employer to make contributions to the accounts of eligible employees. The employer gets a tax deduction for contributions, and the employee is not taxed on those contributions, though their eventual withdrawals will be taxed at their income tax rate. A self-employed person is both the employer and the employee, so they fund their own account."
How Does the Tax Break Work for a Traditional IRA?
The money you contribute to a traditional IRA every year is tax deductible and tax-deferred. That means you can reduce your current taxable income by your contribution amount and pay taxes when you make a withdrawal in the future.
Can I Contribute to an IRA If I Have a Retirement Plan at Work?
Yes. You can contribute to a traditional IRA or Roth IRA even if you have a retirement plan with your employer; however, the amount you can deduct from your contributions will be reduced.
What Is an Excess IRA Contribution?
It's any amount you contribute over the amount allowed by the IRS. This can include rollover contributions. Excess contributions will be taxed at 6% every year that they remain in your account. So you should remove any excess contribution as soon as possible and any income earned on that excess amount.
The Bottom Line
Each of these types of IRAs fits a different profile. Take the time to determine which ones you qualify for and what serves your needs the most. Regardless of which you choose, it's always best to start saving early to take advantage of compounding so that you can ensure a comfortable retirement.
Internal Revenue Service. "IRAs."
Internal Revenue Service. "Traditional and Roth IRAs."
Internal Revenue Service. "SEP Plan FAQs."
Internal Revenue Service. "IRA Deduction Limits."
Internal Revenue Service. "Here’s What People Should Know About Taking Early Withdrawals From Retirement Plans."
Congress.gov. "H.R.1994 - Setting Every Community Up for Retirement Enhancement Act of 2019."
Congress.gov. "One Hundred Seventeenth Congress of the United States of America," Page 831."
Internal Revenue Service. "SEP Plan FAQs."
Internal Revenue Service. "Retirement Topics - IRA Contribution Limits."
Congressional Research Service. "The Taxpayer Relief Act of 1997: An Overview," Page 6.
Internal Revenue Service. "Retirement Topics - Catch-Up Contributions."
Internal Revenue Service. "Amount of Roth IRA Contributions That You Can Make for 2023."
Internal Revenue Service. "Publication 590-A Contributions to Individual Retirement Arrangements (IRAs) 2021," Pages 40–43.
Internal Revenue Service. "Simplified Employee Pension Plan (SEP)."
Internal Revenue Service. "SEP Contribution Limits (Including Grandfathered SARSEPs)."
Internal Revenue Service. "Publication 560 Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans) 2021," Page 7.
Internal Revenue Service. "Publication 590-A Contributions to Individual Retirement Arrangements (IRAs) 2021," Page 31
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