What is the difference between a ROTH, SEP and Traditional IRA?
A SEP is an excellent retirement saving plan for self-employed individuals and small companies that allows your business to contribute and deduct up to 25% of your (and qualifying employees) salary to an IRA account. The maximum contribution to a SEP IRA for 2017 is $54,000. Contributions are tax deductible, grow tax deferred, and are finally taxed as withdrawn from the account.
A traditional IRA and a Roth IRA are retirement saving accounts that allow individuals to save $5,500 per year, or $6,500 per year over age 50. Contributions to a traditional IRA are tax deductible subject to income limitations. Please consult with your tax preparer for specifics. A Roth IRA is not tax deductible, but grows tax free, and withdrawals in retirement are tax free. A Roth IRA is an excellent saving choice for individuals that have a long time until retirement. Eligibility to contribute to a Roth IRA is also subject to income limitations. Please consult your tax advisor for details.
A Roth IRA is one that is funded with after-tax money. Upon reaching retirement age, the contributions and growth are distributed free of any income tax. A SEP IRA is for a self-employed person and it is funded with pre-tax money. Upon retirement, all funds distributed are treated as taxable income. A Traditional IRA is funded with pre-tax money, many times by a worker with W-2 income. Upon retirement, all funds distributed are treated as taxable income. The contribution limits vary over time so be sure to contact your CPA or tax-preparation professional for your particular situation.
The first major difference between the 3 retirement arrangements is that the Roth and Traditional IRAs have nothing to do with an employer; the owner/individual set these two plans up; be it at a bank, brokerage firm, etc. Spousal IRAs/Roth IRAs can also be set up on behalf of a spouse who doesn’t have earned income.
The SEP Simplified Employee Pension Plan, on the other hand, is an IRA set up by one’s employer which allows the employer (and only the employer) to make contributions toward the employee’s retirement. Although, if you are self-employed, you have the ability to open up a SEP and contribute to it on your behalf.
Now let’s talk about contributions. Traditional and Roths only allow yearly contributions in the amount of $5,500 per year, with an additional $1,000 if you are older than 50 years of age. There are contribution limit phase outs depending on if a person is contributing to a company retirement plan and how much annual income an individual has.
With a SEP, the employer has to contribute “equally” to all employees. In this instance, “equally” can mean one of 2 things. It can mean the employer contributes the exact same amount per employee, or the exact same percentage of an employee’s annual compensation. As with Traditional/Roth IRAs, SEP IRAs have contribution limits as well. The maximum contribution amount is 25% of an employee’s annual compensation amount or $54,000; whichever is less.
The Roth IRA was established in 1996 as the newest addition to the individual retirement accounts (IRAs) available to individuals. Its tax treatment differs greatly from most other IRAs. Contribution limits are the same as those for Traditional IRAs, but tax deductions are not available on contributions to Roth IRAs. Unlike all other IRA types, ordinary income tax is not paid on withdrawals. At age 70.5, required minimum distributions (RMDs) are not required.
The simplified employee pension IRA (SEP IRA) allows self-employed individuals to contribute to retirement plans for themselves or their employees without involvement in a complex qualified plan. Many small employers favor SEP plans because of eligibility requirements for contributors, including minimum age of 21, at least three years of employment and a $500 compensation minimum. In addition, an SEP IRA allows employers to skip contributions during years when business is down. Contributions made by employers cannot exceed the lesser of 25% of an employee's compensation, or $46,000 maximum (for 2008). As with the Traditional IRA, withdrawals from SEP IRAs in retirement are taxed as ordinary income.
However, age 70.5 withdrawal requirements apply.
The Traditional IRA is the most common type of IRA. Millions of 401(k) and other company retirement plans are rolled over into Traditional IRAs each year when workers retire or change employers. Unlike the Roth, tax deductions for annual contributions may apply to this type of IRA when income falls below certain limits. Unfortunately, the IRS views those funds as pretax contributions and, when withdrawals are made later in life, the withdrawals are then taxed as ordinary income. At age 70.5, Traditional IRA holders are required to take RMDs.
This question was answered by Steven Merkel.