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A simplified employee pension (SEP) individual retirement account (IRA) is a retirement savings plan established by smaller employers—including self-employed people—for the benefit of their employees and themselves. Employers may make tax-deductible contributions to eligible employees’ SEP IRAs on their behalf.
Because SEP and traditional IRAs are the same type of retirement savings account, you can roll the SEP into a traditional IRA without owing taxes. However, being able to convert the SEP IRA into a Roth IRA will depend on your income, ability to pay the tax on the Roth contribution, and other restrictions.
Key Takeaways
- SEP IRAs are qualified retirement accounts set up by small businesses that allow for employer contributions and larger contribution limits than conventional IRAs.
- Rolling a SEP account into a traditional IRA is fairly straightforward because both are treated the same by the IRS and use pretax dollars.
- Converting a SEP IRA to an after-tax Roth IRA may trigger a taxable event, as well as the other restrictions on Roth accounts that must be considered.
What’s Good About a SEP IRA?
SEPs are advantageous because they are easy to set up, have low administrative costs, and allow an employer to determine how much to contribute each year. SEP IRAs also have higher annual contribution limits than standard IRAs.
Fundamentally, a SEP IRA can be considered a traditional IRA with the ability to receive employer contributions. One major benefit of a SEP IRA is that employer contributions are vested immediately.
However, sometimes you might need to roll your SEP into a different qualified retirement account—for instance, if you change jobs or the employer goes out of business.
Converting to a Traditional IRA
The SEP IRA and the traditional IRA are very similar. Both take pre-tax contributions and tax deductions on eligible contributions. And both offer tax-deferred growth. But there are differences. A key difference is that the SEP IRA is funded solely with employer contributions. These contributions go into SEP IRAs owned by each eligible employee, including a self-employed business owner’s. In contrast, a traditional IRA can only take contributions from the individual account owner. Still, you can combine a SEP IRA into a traditional IRA without any taxable ramifications.
When performing such a combination, to ensure the rollover is a non-taxable event, the move should be done and documented as a trustee-to-trustee direct transfer. This will be a reportable event on your taxes, but you will not owe any taxes. With such a transfer, an account owner will receive a Form 1099-R for the SEP portion of the transfer and a Form 5498 for the traditional IRA portion.
Converting to a Roth IRA
Whether a conversion to a Roth IRA is good for you depends on your financial profile. In general, if you meet the income restrictions and can afford to pay the taxes that would be due on the conversion—and your tax bracket during retirement will be higher than your tax bracket now—it makes sense to convert your assets to the Roth IRA.
That may sound very general, but only someone familiar with your finances could make a specific recommendation. Note, however, that there’s a five-year rule for Roth IRA distributions, so also consider your age and how long it will be before you retire before you decide to make the transfer.
At a minimum, you can combine the SEP and traditional IRA to reduce any administrative and trade-related fees that may be charged to the accounts.
Advisor Insight
Arie Korving, CFP
Korving & Co. LLC, Suffolk, VA
There are two issues to consider. If you roll a SEP IRA into a traditional IRA, assuming you do it right, there are no taxes to pay and your money will continue to grow tax-deferred until you begin taking withdrawals.
If you decide to roll it into a Roth IRA, you will owe income tax on the amount rolled over. However, the money will then grow tax-exempt, as there will be no taxes to pay when you begin taking withdrawals.
Be sure to know ahead of time how much you will have to pay in taxes. Also, try to avoid using some of the rollover money to pay the tax, because, depending on your age, it could trigger an early withdrawal penalty.
It’s up to you to decide which option works best. If you are unsure, you may want to consult a financial planner.
Are SEP IRAs and Traditional IRAs Similar?
Yes. For this reason, rolling a SEP account into a traditional IRA is fairly simple because both are treated the same by the IRS and use pretax dollars for employer or account holder contributions. It’s possible to consolidate the SEP and traditional IRAs you have to minimize administrative and trade-related fees that may be assessed.
What Are Some Problems That Might Arise When Converting a SEP IRA to a Roth IRA?
Converting a SEP IRA to an after-tax Roth IRA may trigger a taxable event, and you may not qualify due to income restrictions on Roth accounts that must be considered. Also, you will owe income taxes for that tax year on the entire balance because you’re rolling over funds from an account funded with pretax dollars to one funded with after-tax dollars offering tax-free withdrawals. How much tax you pay will depend on your tax bracket and the amount you convert (which is taxed as ordinary income). Also, if you make a withdrawal from a retirement account like a SEP IRA before it’s allowed (at age of 59½), the IRS imposes an early withdrawal penalty.
Who Shouldn’t Consider Converting a SEP IRA Into a Roth IRA?
For some people, sticking with a traditional IRA or SEP IRA might be a better strategy than rolling the funds into a Roth IRA. This may be true if: You’re near or in retirement and need your traditional IRA to cover your living expenses. Your converted assets may not have time to recoup the taxes you would have to pay; you’re receiving Social Security or Medicare benefits, because if a Roth conversion were to increase your taxable income, then more of your Social Security benefits would be taxed and your Medicare costs could rise; or you don’t have enough money to pay the conversion tax and must sell assets that could end up increasing your tax bill. Using IRA funds to pay for the conversion tax could negate the benefits of converting.
The Bottom Line
Because SEP and traditional IRAs are essentially the same type of retirement savings account, you can roll the SEP into a traditional IRA easily without owing taxes. But being well-suited and eligible to convert your SEP IRA into a Roth IRA will depend on your income, ability to pay the tax on the Roth contribution, and other IRS restrictions.