SEP IRA vs. Roth IRA: How do they compare?

When you run a small business or you're self-employed, saving for retirement isn't as straightforward as electing to reroute a portion of your salary to a 401(k). Saving for your future self—and possibly helping any employees you have to save as well—is up to you to establish.

Two common options for putting away some of your income for retirement are simplified employee pension plan (SEP) IRAs and Roth IRAs.

Each can provide you with certain tax advantages, but they don't work the same way. They have distinct characteristics and rules regarding their contributions, taxation and distributions. Read on to learn more about how these accounts compare to each other and when you may want to consider one or both.

A SEP IRA is a retirement plan that an employer of any business size may offer as a benefit, whether you have employees or are entirely self-employed. You need only take the steps to establish the SEP IRA and then begin making contributions.

It's important to note that, unlike traditional employer-sponsored plans, only the employer can make SEP IRA contributions. You'll be required to contribute an equal percentage of each qualified employee's pay to their SEP IRA, up $66,000 in 2023 or $69,000 in 2024, or a maximum of 25% of their salary, whichever is less. If you're a sole proprietor, you will have a 20% limit that applies to your net earnings from self-employment.

You easily can set up a SEP by completing an IRS plan document. It will establish the allocation and eligibility rules. The IRS has certain minimum eligibility requirements: Participants must be 21 or older, have worked for the employer for at least three of the previous five years and receive at least $750 in compensation—though employers can be less restrictive if they want.

Establishing a SEP IRA for your business may allow you to claim the Retirement Plan Startup Costs Tax Credit. This credit is designed to help offset startup costs for small businesses that set up retirement plans for their employees, and it's worth up to $5,000 per year for three years.

A Roth IRA is an individual retirement account you can open on your own at any time, regardless if you have an employer, are self-employed or own a business—as long as you or your spouse have earned income and you're under the IRS income limit.

Unlike traditional IRAs, you fund a Roth IRA with dollars you've already paid income taxes on. Then, your earnings and qualified distributions are tax-free.*

Roth IRAs have annual contribution limits:

• 2023 contribution limit: $6,500; $7,500 if you're 50 or older.
• 2024 contribution limit: $7,000; $8,000 if you're 50 or older.

While both of these accounts help you save for retirement, SEP IRAs and Roth IRAs don't operate in the same ways. When you contribute to a SEP, you're doing so as an employer, even if you're self-employed. Meanwhile, any individual can contribute to a Roth IRA. Depending on if and how many employees you have, this can mean a difference in the level of set-up and maintenance work required. They also differ in their contribution limits, their tax implications and their distribution rules.

The IRS limits how much you can contribute in total to all of your personally held traditional and Roth IRAs to the annual limit, with the exception of rollovers.

With a SEP IRA, you can contribute up to 25% of your salary (20% of net earnings from self-employment if you are a sole proprietor) up to $66,000 in 2023 or $69,000 in 2024. You must contribute the same percentage to all eligible participating employees, as well.

You fund Roth IRAs with money you've already paid income taxes on. But even though you pay taxes on them in the year you contribute, you enjoy tax-free growth of earnings and tax-free qualified distributions. The withdrawal rules to keep the earnings tax- and penalty-free generally include being at least age 59½ (or meeting certain exceptions if you're withdrawing early) and having owned the account for at least five years.

With a SEP IRA, your contributions are, instead, tax-deferred. This means you don't pay taxes when you put the money into it or while the earnings are growing. But your withdrawals are taxable when you take them. That's regardless of your age when you withdraw, but as long as you're at least 59½, you typically won't pay a penalty.

Certain retirement accounts have required minimum distributions (RMDs). You have to take a certain amount of money—as determined by IRS worksheets and calculation tables—out of your account by April 1 of the year after you turn 73 and every year after.

• SEP IRAs have RMDs. Remember, the taxes on these are deferred (you don't pay them until you withdraw your money), and the IRS wants to be able to take its cut at some point.

• Roth IRAs are not subject to RMDs. So, if you don't need the money in retirement, you can leave it in your account indefinitely. However, your beneficiary will be subject to specific withdrawal requirements.

Happy cafe owner running her business on a digital tablet

Happy business owner using a digital tablet in her cafe. Mature female cafe owner smiling cheerfully while standing in front of the counter. Successful entrepreneur running her business online.

Trying to decide on a retirement plan for your small business?

SEP and SIMPLE IRAs are two of the most popular and convenient ways for a business owner to contribute to both their own and employees' retirement savings. But how do you choose between them?

Compare the differences

Neither account is fundamentally better than the other because they serve different purposes. It depends on your situation. SEP IRAs have higher contribution limits that allow you to save more, and you may benefit from an immediate tax deduction. Roth IRAs grow tax-free, and you don't have to worry about RMDs.

Here are some scenarios to help you decide:

• A SEP IRA may be a better choice if you have a high income. A Roth IRA may not allow you to save enough to replace your income in retirement, and you may not qualify anyway. Having a higher income also likely means you're in a higher tax bracket, so the immediate tax deduction may be more valuable.

• Roth IRAs are a good way to grow a tax-free nest egg as long as you or your spouse have earned income and you make under the IRS income limits. Although they have a low annual contribution limit, you can use them alongside a workplace plan.

You have the option to contribute to both a SEP IRA and a Roth IRA. You could offer a SEP IRA as a small business owner or have one as a self-employed person and also put money in a Roth IRA. This can be a tax-wise move and a particularly strong strategy if you're able to max out annual contributions to your Roth IRA because you'll have your completely separate SEP IRA to keep contributing to.

These are just two of many different retirement account options you may have. An experienced Thrivent financial advisor can work with you to review your overall financial picture and help you decide which retirement options can best meet your needs.