Roth IRA vs. SEP if Self-Employed

Using qualified retirement plans like Roth IRAs and SEPs saves you on taxes.

Using qualified retirement plans like Roth IRAs and SEPs saves you on taxes.

When you're self-employed, you've got to take it upon yourself to set up your own retirement plan. Setting up a simplified employee pension, or SEP, is less complicated than a full-blown 401(k) plan, and offers several benefits over a Roth IRA. You don't have to be self-employed to have a Roth individual retirement account, but it might still be your best option. If you can't decide and have the money, you can even contribute to both.

Roth IRA Advantages

If you're willing to sacrifice a tax deduction now, Roth IRAs can save you lots of money in the future. See, you won't get a tax deduction for contributing, but you get to take out qualified distributions, including all your earnings, tax-free. Not only that, if you run into trouble and need to take out money before you retire, you can take out your contributions whenever you want, tax-free and penalty-free, and the IRS won't even ask why you need the money. Finally, if you never liked math, Roth IRAs also offer simpler contribution limit calculations: If you're eligible, you get to contribute up to the lesser of the annual contribution limit -- $5,000 as of 2012 -- or your compensation for the year.

Roth IRA Drawbacks

Roth IRAs aren't perfect for everyone. First, not everyone can contribute because of the limits the IRS imposes on your modified adjusted gross income for the year. In short, if you're making too much dough, you can't contribute. Second, if you're in a higher tax bracket now than you anticipate being in at retirement, a pretax retirement plan may be better for you. Finally, the contribution limits might be a lot lower than a SEP if you're making bank from your self-employment, so you could be missing out on a chance to stash away some extra cash for retirement.

SEP Advantages

SEPs offer the opposite tax benefits of a Roth IRA. You get to deduct your contributions, but you'll pay taxes on your distributions. In short, save now, pay later -- this benefits you if you expect to pay a lower tax rate in retirement. In addition, the SEP contribution limits have the potential to be much higher than a Roth IRA, which allows you to stash away more for your nest egg. As of 2012, you're limited to the smaller of 20 percent of your net self-employment income or $50,000. For example, if you have $100,000 of self-employment income, you can dump up to $20,000 into your SEP.

SEP Disadvantages

Besides not allowing you to save for retirement on an after-tax basis, SEPs can get messy if your self-employed business has employees. Since a SEP is an employer plan, you'll have to set up and contribute to SEPs for each of your "eligible employees." Eligible employees are people who are at least 21 years old, have worked for you in three of the last five years and have made the minimum - $550 as of 2012. As a result, setting up and maintaining a SEP might be more trouble than it's worth.

 

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