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SEPTEMBER 14, 2020

As a small business owner, why open a SEP IRA vs. a Roth or Traditional IRA?

Answered by
Judith Anderson
Senior Vice President, Retirement & Personal Wealth Solutions at Bank of America
A SEP (Simplified Employee Pension) IRA is usually preferable because it lets small business owners make larger tax-deductible contributions to their employees' — and their own — retirement savings than individuals can make to Traditional or Roth IRAs.

Top 3 advantages of a SEP IRA over a Roth or Traditional IRA

"You can decide each year how much to contribute for you and your employees. If times are tight, you can reduce or skip contributions."
— Judith Anderson, Senior Vice President, Retirement & Personal Wealth Solutions at Bank of America
  1. Higher contribution limits: You can set aside as much as 25% of your employees' compensationFootnote 1 — up to $57,000 in 2020 ($56,000 for 2019) — to the SEP for all eligible employees. With a Traditional or a Roth IRA, an individual's contributions are generally limited to $6,000 a year in 2019 and 2020, or $7,000 for those age 50 and older. If you're self-employed, use the Deduction Worksheet for Self-Employed in IRS Publication 560, Retirement Plans for Small Business, to calculate your maximum SEP contribution.
  2. Greater flexibility: You can decide each year how much to contribute for you and your employees. If times are tight, you can reduce or skip contributions. But keep in mind that the contribution formula — such as a percentage of compensation — must be the same for all participants, including you.
  3. Bigger tax advantage: Contributions to both a SEP and a Traditional IRA are made pre-tax — but the amount an employer can contribute annually to a SEP is higher (see point 1 above). Your employees can make their own Traditional IRA contributions to the same account that holds their SEP contributions rather than maintaining a separate IRA. One cautionary note: while employees can contribute to their own Traditional or Roth IRA, they are considered to be covered by a retirement plan at work: the SEP. This could have an impact on their ability to make deductible Traditional IRA contributions.
SEP IRA Roth IRA Tradi­tional IRA
Who's it for? Small business owners and the self-employed Individuals Individuals
Max contribution in 2020 25% of compensation,Footnote 2 up to $57,000 in 2020 — ($56,000 for 2019) Generally, $6,000 ($7,000 if you're age 50 or older)Footnote 3 Generally, $6,000 ($7,000 if you're age 50 or older)Footnote 4
Type of contribution Pre-tax After-tax Pre-tax
Can I roll over funds to and from other IRAs? Generally, yes Generally, yes Generally, yes
Are distributions subject to federal income tax? Yes No, provided certain requirements are met Yes
Required minimum distribution at age 72?Footnote 5,6 Yes No, provided you are the original owner Yes

What else is there to know about SEP IRAs?

SEP IRAs are easy to set up and manage, and in addition:
  • Retirement contributions and plan expenses are tax-deductible for business owners.
  • You have until your tax filing deadline — March for corporations and April for everyone else — to make contributions for you and your employees. If you file for an extension, you can delay making contributions until the extended filing deadline — September for corporations and October for everyone else, rather than the standard April deadline. Many small business owners find this helpful in managing cash flow.
  • Money in a SEP IRA isn't taxed until withdrawn, when distributions are considered ordinary income.

When might it make sense to consider a 401(k)?

As your business grows, the simplicity of a SEP IRA may start to feel restrictive — if, for example, your employees want to use salary deferrals to save more for retirement. That's not possible in a SEP IRA, but it is allowed in a 401(k) plan.
Help when you want it
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Footnote 1 The maximum compensation that can be taken into account for purposes of this calculation is $285,000 per participant for 2020 ($280,000 for 2019).

Footnote 2 Subject to annual limits on eligible participant compensation. If you're self-employed, the maximum percentage may be 20% of net earnings from self-employment (determined under the SEP IRA rules). See IRS Publication 560, Retirement Plans for Small Business.

Footnote 3 A lower limit may apply, depending on your income and other factors.

Footnote 4 A lower limit may apply if you or your spouse is eligible to participate in an employer-sponsored retirement plan.

If you were age 70½ or older as of 12/31/2019, you would be required to take a required minimum distribution ("RMD") from your traditional IRA and certain other qualified retirement plans for 2019. Effective 1/1/2020, in accordance with new legislation, the required beginning date for RMDs for individuals who turn age 70½ on or after 1/1/20 is age 72. You may defer your first RMD until April 1 in the year after you turn age 70½ or 72, as applicable, but then you'd be required to take two distributions in that year. Note that coronavirus legislation eliminated RMDs for 2020, including RMDs to beneficiaries of Roth IRAs.
Footnote 6 Under the CARES Act, all 2020 RMDs have been waived. There are no coronavirus eligibility requirements associated with this change. For 2020 distributions that were RMD payments but for the law change, the following relief is available to restore these funds to an IRA:
  • 2019 RMDs that were not taken before January 1, 2020 and that were required to be taken by April 1, 2020 are also waived.
  • Distributions received as RMDs in 2020 are eligible for rollover.
  • The 60 day rollover period for IRA distributions that would have been RMDs but for the CARES Act waiver taken after December 31, 2019 and prior to July 2, 2020 has been extended to August 31, 2020.
  • Waived RMDs taken from beneficiary accounts may be recontributed to the distributing inherited IRA account by August 31, 2020.
  • Distributions taken after July 1, 2020 are subject to the regular 60 day rollover rule.
  • The one-rollover-per-year rule does not apply to the repayments of these RMDs to the distributing account by August 31, 2020.

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