If you are self-employed, have freelance income or are the owner of a small business, you might want to consider opening a Simplified Employee Pension Individual Retirement Account (SEP IRA). A SEP IRA offers some advantages over a Traditional (or Roth) IRA, including a higher contribution limit.

Of course, a SEP IRA is not your only retirement savings option, so it’s important to know what a SEP IRA is, how it works and then compare it to the alternatives before making a final decision about opening one.

What Is a Simplified Employee Pension (SEP) IRA?

Basically, a SEP IRA is a retirement plan available to self-employed individuals or small-business owners. Contributions are tax deductible and reside in a Traditional IRA in the name of the self-employed individual, small-business owner (or employee).

One big advantage of a SEP IRA is its high contribution limit—up to 25 percent of income or $54,000, whichever is less. An account is easy to open at a bank, mutual fund company or brokerage, and fees are typically low.

Also important: A SEP IRA offers funding flexibility. You can decrease or increase the percentage of your contribution, depending on your income. In a bad year, you can even cut off funding altogether.

If you open a SEP IRA as a small-business owner and have qualified employees, you must contribute the same percent of salary for all. (Employees can’t make contributions to the SEP themselves; as the business owner, you put in money on their behalf.) A qualified employee is anyone 21 years of age or older who has received at least $600 in compensation during the year and has worked for you three out of the previous five years. For more see: SEP Plan FAQs from the IRS.

A piece of paper with the word SEP IRA on it.

The SEP IRA vs. the Traditional IRA

The main difference between a Traditional IRA and a SEP IRA is the contribution limit: 25 percent of income for a SEP IRA versus $5,500 a year ($6,500 if you are age 50 or over) for a Traditional IRA.

Beyond that, there are few differences. Anyone can open a Traditional IRA, but only someone who is self-employed or a small-business owner can open a SEP IRA. (As you’ll see below, you can actually have both.) What’s more, a Traditional IRA has a $1,000 catch-up provision for those aged 50 and over (mentioned above), whereas the SEP IRA has none.

Both a Traditional IRA and a SEP IRA are subject to required minimum distributions (RMDs) at age 70½. Other Traditional IRA rules apply as well.

What About the Roth IRA?

A SEP IRA cannot accept Roth (post-tax) contributions. You can, however, contribute to both a Roth IRA and a SEP IRA in the same year. SEP IRA limits are separate from those for Traditional and Roth IRAs.

Unlike a Traditional or SEP IRA, contributions to a Roth IRA are made after-tax. There is no tax deduction in the year you make the contribution. However, both your original contribution and all earnings are tax free when you withdraw them in retirement. What’s more, you have access to your contributions (not your earnings) at any time, should you need them, without penalty.

Paying taxes now, as you do with a Roth IRA, protects you if you expect to be in a higher tax bracket when you retire. In addition, a Roth account allows you to withdraw your (already taxed) contributions at any time without penalty.

Finally, both SEP IRAs and Traditional IRAs have a required minimum distribution (RMD) after you turn 70½. Roth IRAs do not.

However, there are income limits on who is eligible to contribute to a Roth. if your business is doing very well, you may earn too much.

Choosing the Right IRA for You

You don’t have to decide between a SEP IRA and a Traditional IRA. If you do only one, the SEP IRA probably makes more sense, assuming you qualify, since you can make a much larger contribution. But you actually can contribute to both. The only limitation, depending on your income, is that having SEP plan could mean that your Traditional IRA contributions won’t be tax deductible.

When it comes to opting for a SEP versus a Roth IRA, you also don’t have to make a choice. You can do both, as well.

If you feel you must choose, your decision will likely depend on whether you believe your tax bracket will be higher or lower in retirement and whether you want the security of having access to your contributions between now and when distributions begin. And, of course, you will want to consider whether you are comfortable with having an RMD, starting at age 70½.

While this decision is not hugely complicated, it’s always good to seek the advice of a trusted financial professional before moving forward on these important matters. 

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