Tradition, Roth, and SEP IRA: What's the Difference?

Roth IRAs, traditional IRAs, and SEP IRAs are three types of individual retirement accounts, and they're similar in many ways. But there are some key differences in how they work, which can make one kind better for someone than another.

Here are the basics, starting with the best-known and most common kind of individual retirement account: the traditional IRA.

Key Takeaways

  • Roth, traditional, and SEP IRAs can serve different purposes for different people.
  • With a traditional IRA you get an upfront tax break, while with a Roth your tax break comes later.
  • If you have self-employment income, a SEP IRA will allow you to save more for retirement than either a traditional IRA or a Roth.

Traditional IRAs

With a traditional IRA, you can put pre-tax income into the investments of your choice, which will then grow tax-deferred until you eventually withdraw the money. 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 meet the other eligibility requirements (such as not having access to a workplace retirement plan for you or your spouse). When you later withdraw money from the account, typically in retirement, it will be taxed as ordinary income. After age 70½, you must begin to take required minimum distributions (RMDs) from the account each year, according to a formula based on your age at the time. The money in a traditional IRA can't grow tax-deferred forever.

As of 2019, traditional IRA contributions are capped at $6,000 a year, with the option of an additional $1,000 catch-up contribution if you're 50 or older, for a total of $7,000.

If you don't have a work-place sponsored retirement plan, and/or if you think you'll be in a higher tax bracket after you retire than the one you're in now, a traditional IRA can be a good savings option.

Roth IRAs

Another type of individual retirement account, the Roth IRA, was introduced in 1997. It works much like a traditional IRA, but in reverse.

The contribution limits on Roth IRAs are the same as for traditional IRAs—including catch-up contributions—but you won't receive any upfront tax deduction. Instead, you'll get a tax break later, when the money you withdraw will be tax-free. For that reason, Roth IRAs are an attractive option for people who expect to be in a higher tax bracket after they retire than they are currently.

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, you can simply pass it along 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. In 2019, for married filers who submit a joint tax return, the amount you can contribute is reduced for those who make more than $193,000 and is completely phased out if they make $203,000 or more (in 2020, the range is $196,000-$206,000). For single filers, the range is $122,000 to $137,000 in 2019 and $124,000-$139,000 for 2020.

With a SEP IRA, there are no catch-up contributions for people age 50 and over.

SEP IRAs

A simplified employee pension (SEP) IRA is a type of individual retirement account that can be opened by an employer, who might simply be a self-employed individual. 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. 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 either a traditional or Roth IRA. You can contribute up to 25% of your compensation or $56,000 (for 2019), 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.

Advisor Insight

Rebecca Dawson
Dawson Capital

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 employer and employee so they fund their own account.