SEP vs. Roth IRA for Small Business: Which Is Better?

Two Small Business Retirement Plans Compared

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When your business is profitable, you may want to put aside money from your earnings for retirement and save on taxes, too. Creating an individual retirement arrangement (IRA) is one option, and there are several types from which to choose.

This article compares two of the most common types of IRAs for business owners: A SEP IRA and a Roth IRA.

SEP IRA vs. Roth IRA for a Small Business: What’s the Difference?

An IRA allows you to set aside money for retirement, either tax-deferred until your retirement or after-tax at the time of the contribution.

A SEP IRA is part of a simplified employee pension (SEP) plan that allows you to put money into an IRA (specifically, a SEP IRA) using your business earnings, with tax-deductible contributions. You may also include employees in this plan by making contributions for their individual SEP IRAs.

A Roth IRA is an IRS-qualified retirement plan that works in the opposite way from a traditional IRA. You contribute to this IRA with after-tax money, then you can make tax-free withdrawals if you meet specific requirements.

SEP IRAs vs. Roth IRAs at a Glance

Here is a quick glance at key differences between SEP and Roth IRA for businesses.

  SEP IRA Roth IRA
Who Can Participate? Business owners and employees Owner only
Business Types  All types, including corporations Only individual owners
Tax on Contributions and Distributions  Tax deferred, then taxable in year of withdrawal Taxable in year of contribution; no tax on withdrawal
Setup Process Plan document  for SEP Plan + individual SEP IRAs for employees Plan document
Annual Contribution Limits Lesser of  25% of pay or $61,000 Up to $6,000
Operating Costs Higher if employees participate Similar to other IRAs
Distribution Requirement Required minimum distribution (RMD) required after you reach age 72 No RMD required

Who Can Participate?

You can set up a SEP retirement plan that allows you to create and fund SEP IRAs for yourself and your employees. As a business owner, you can contribute to your own SEP IRA if you receive compensation from the business, as defined in your SEP plan documents. Employees must meet certain IRS eligibility requirements, and all who are eligible must be included in the plan.

Roth IRAs essentially are individual IRAs. You can set up a Roth IRA for yourself as a business owner and make contributions to it from your business earnings or other earnings.

Note

If you want to give employees the option of a Roth IRA, you can create a payroll deduction IRA to which the employee makes contributions to individual Roth IRAs through payroll deductions. Employers don’t have to contribute to a payroll deduction IRA.

Business Types

Sole proprietors, partnerships, S corporations, and corporations can set up a SEP and a SEP IRA for themselves as business owners. You don’t need to have employees to have a SEP IRA. You can set up a Roth IRA for yourself and fund it with business income, but it’s not considered part of your business.

Tax Status of Contributions and Distributions

Contributions to a SEP IRA are tax deductible, meaning you don’t have to pay taxes on the earnings from this investment until the year when you take them out as a distribution.

Contributions to a Roth IRA, on the other hand, are not tax deductible, but you may take money out at any time tax-free, because you have already paid the tax. However, there are some restrictions on distributions (explained below).

Setup Process

The setup process is similar for both SEP IRAs and Roth IRAs. First, you will need to find a financial institution such as a bank, life insurance company, or stockbroker to be your trustee. They will help you set up an investment account and complete a plan document describing the terms of the plan.

Setting up a SEP IRA, meanwhile, can be more complicated and costly if employees will be in the plan. This is because you must create a formal written agreement with language describing employee rights and benefits.

Note

The IRS has a model plan agreement for each type of plan so you can see what needs to be included in the document. The SEP document is Form 5305-SEP and the Roth document is Form 5305-R.

Contribution Limits

You can make contributions to SEP IRAs each year for eligible employees and yourself, up to the lesser of 25% of each employee’s compensation for the year or a dollar amount that changes each year. The limit for 2022 is $61,000.

The annual contribution limit for Roth IRAs depends on your tax filing status (married, single, etc.) and your modified adjusted gross income (MAGI) for the year. You MAGI must be under a specific amount for you to make contributions. For example, if your tax status is married filing jointly, your MAGI for 2022 is reduced after $204,000 with a contribution limit of $214,000.

If you have both a Roth IRA and a traditional IRA (not a SEP IRA), there is a maximum contribution limit. For 2022, the combined limit can’t be more than the lesser of $6,000 ($7,000 if age 50 or older) or your taxable compensation for the year.

Note

As of 2020, there’s no limit to the contributions you can make to SEP IRAs or Roth IRAs after age 70 ½.

Operating Costs 

The operating costs for most types of IRAs are similar. They involve administrative fees and brokerage fees for trading, with amounts depending on your trustee. Costs for SEP IRAs with employees are higher, depending on the number of employees. You must pay fees to your trustee for setup and operations, including periodic reports to employees.

Distribution Requirement

You don’t have to pay income taxes on SEP IRAs until you take out funds from the account, but you must begin to take required minimum distributions (RMDs) each year after age 72, with the amount included in your taxable income for the year. The RMD amount is based on the balance in each type of IRA. If you have a Roth IRA, you don’t have to take a minimum amount out of the plan, since you have already paid the taxes on your contributions.

Special Considerations and Restrictions

Here are some considerations and restrictions to keep in mind with both SEP and Roth IRAs:

  • A SEP IRA can’t be a Roth IRA. It must be a traditional IRA with before-tax money set aside.
  • Business owners and employees can contribute to a SEP IRA and also have a Roth or traditional IRA.

Note

You may be eligible for a tax credit to help you pay for the cost of setting up a SEP plan and SEP IRAs for yourself and your employees. The credit is up to $500 for each of the first three years.

Which Is Right for You?

A major factor in choosing between a SEP IRA and a Roth IRA is whether you have employees you want to help plan for retirement by funding IRAs for them. You must contribute equally to all eligible employees; you can’t make a contribution to your own SEP RA without making a contribution to employees. However, you don’t have to contribute a specific amount in any year, and you can even skip a year.

One advantage of SEP IRAs is the higher limit on annual contributions: 25% of compensation versus $6,000 for a Roth IRA ($7,000 if you are age 50 or older by the end of the year). On the other hand, your funds in a Roth IRA can grow tax-free, and you aren’t required to take out a minimum amount at any time. This can be an advantage depending on your income level at the time when you take out the money.

If you have employees, you might want to consider a SEP plan with SEP IRAs for yourself and your employees. Setup and operation of a SEP plan with employees is greater than these costs for a Roth IRA, but giving employees money for retirement can be a big incentive in attracting new employees.

If you don’t have employees, you can create either a SEP IRA or a Roth IRA for yourself as a business owner. You may also decide to have both a pre-tax SEP IRA and an after-tax Roth IRA, up to the limits described above.

Before You Choose

There are many qualifications and restrictions with all types of IRAs, and your tax position, now and in the future, is an important factor in the decision to select an IRA. Before you make any decisions, discuss your options with both a licensed tax professional and an investment advisor.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. National Foundation for Credit Counseling. “Retirement Plans for Business Owners and Their Tax Implications.”

  2. IRS. “Simplified Employee Pension Plan (SEP).”

  3. IRS. “Payroll Deduction IRA.”

  4. IRS. “SEP Contribution Limits (Including Grandfathered SARSEPs).”

  5. IRS. “Amount of Roth IRA Contributions That You Can Make for 2022.”

  6. IRS. “Retirement Topics - IRA Contribution Limits.”

  7. IRS. "Retirement Plan and IRA Required Minimum Distributions FAQs."

  8. U.S. Department of Labor. "SEP Retirement Plans for Small Businesses," Page 1.

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