SEP or Roth IRA?

Mar 9, 2020 by

SEP or Roth IRAContinuing with the ‘focus on freelancer’ theme I launched with Freelancer Taxes, let’s get into whether self-employed U.S. taxpayers are better off saving for retirement in a Roth IRA or a Simplified Employee Pension Plan (SEP) IRA.

Self-Employed Taxpayers Have Three IRA Choices!

One of the many benefits of self-employment is access to a third tax-advantaged way to stash cash for spending after age 59½. The three IRAs from which freelancers can choose are:

  • Traditional IRA
  • Roth IRA

You likely already know about Traditional and Roth IRAs. SEP IRAs are less well known, but every self-employed person—and also people with side businesses in addition to traditional paid employment working for someone else’s business—should make a point of learning about SEP IRAs. The incremental financial rewards could truly be life altering.

The SEP IRA vs. Traditional IRA

The tax advantage of a SEP IRA is the same as for a Traditional IRA: if you meet the criteria, your contributions to either of these IRA accounts are tax deductible for the year you make the contribution.

But there’s a huge difference between SEP IRAs and Traditional IRAs:

SEP IRA Contribution Limits

If you’re self-employed, to the IRS you are running a business, whether or not it feels like that to you. You will file a Schedule C, Profit or Loss from Business, along with your 1040. The amount you can contribute to a SEP IRA is 18.6% of your business’ net profit, as reported on Line 31 of Schedule C.*

How large does your business’ net profit have to be so that the maximum SEP IRA contribution matches the maximum Traditional IRA contribution ($5,500 or $6,500)? Here you go:


This means that if you’re under age 50 and your self-employed business’ net profit exceeds $30,000 in 2016, you can make a larger contribution to a SEP IRA than to a Roth IRA.

Let’s say your 2016 net profit is $100,000. You could contribute up to $18,600 to a SEP IRA. The much larger (vs. a Traditional IRA) grows your retirement fund much faster—directly because of the larger contribution, and indirectly because you’ll have more money to invest that then generates more tax-deferred returns.

Further, though you may not be able to deduct 100% of your SEP IRA contribution ($18,600 in my example), you’d likely be allowed to deduct more than the $5,500 Traditional IRA maximum, slashing your tax bill and putting more money in your pocket vs. a Traditional IRA. The IRS provides a worksheet to help calculate how much of your SEP IRA contribution you can deduct.

To me this adds up to a “no-brainer.” I see no downside—and tremendous potential upside—in choosing a SEP IRA over a Traditional IRA. If you’re self-employed, forget about Traditional IRAs.

SEP IRA vs. Roth IRA

With Traditional IRAs tossed, your choice as a freelancer reduces to SEP vs. Roth.

The standard Roth vs. Traditional arguments apply here, because, like Traditional IRAs, SEP IRA contributions are tax deductible, but Roth contributions are after-tax—no deduction. However, you pay no tax on Roth withdrawals while both SEP and Traditional IRA withdrawals are taxed at your tax rate in the year of withdrawal.

Which is better—a front end or back end tax benefit? No one can know for sure, because no can know your tax rate when you make withdrawals.

We could argue this point for days, but I’ve tended to opt for the front end tax benefit offered by Traditional and SEP IRAs. I like to get my money from Uncle Sam now, not after I’m age 59½. What if I croak at age 59¼? Man, that would suck for several reasons, but I sure wouldn’t want my last thought to be “damn—I should have made tax deductible IRA contributions!” 🙂 Also, getting money now instead of later is always better because I can invest that money and boost the ‘return’ on my front end tax deduction.

But how ever you resolve for yourself the front end vs. back end IRA tax benefit question, here’s what may really matter: The maximum Roth contribution is the same as the Traditional IRA contribution, so the same argument presented above for SEP vs. Traditional applies. You can contribute potentially far more to a SEP IRA than you can to a Roth IRA.

To restate: you can contribute only $5,500 to a Roth IRA in 2016 if you are under age 50. But if the net profit from your freelance endeavors in 2016 is greater than about $30,000, you have the opportunity to contribute more than $5,500 to a SEP IRA, cut your current tax bill commensurately, and build your retirement fund faster by generating more tax-deferred earnings inside your retirement account.

SEP vs. Roth IRA Bottom Line

→ If Line 31 on Schedule C (net profit) is more than $30,000, go with a SEP IRA, and contribute the max!

→ If your net profit is under $30,000, go with a Roth or Traditional IRA, depending on whether you prefer a back end (Roth) or front end (Traditional) tax benefit.

One caveat: Not every taxpayer is allowed to contribute up to $5,500 to a Roth IRA in 2016. The rules can be complex and are income-dependent, so be sure you know what your personal maximum Roth contribution will be, and factor that into your personal SEP vs. Roth decision making.

How to Set Up a SEP IRA

Establishing a SEP IRA is a cinch:

  1. Complete IRS Form 5305-SEP, “Simplified Employee Pension—Individual Retirement Accounts Contribution Agreement”
  2. Keep a copy of 5305-SEP and send a copy to an investment firm or brokerage of your choice (I recommend Vanguard) that will be acting as your trustee.

Once set up, a SEP-IRA requires no further administration. It’s identical to Roth and Traditional IRAs.

Now was that hard?


*18.6% is the SEP contribution limit for self-employed persons after net profit is adjusted for the deduction for self-employment tax (FICA) levied on net earnings.

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