Traditional vs. Roth vs. SEP IRA: Differences?

Traditional vs. Roth vs. SEP IRA: An Overview

Officially, an IRA is defined as an individual retirement arrangement by the U.S. Internal Revenue Service (IRS). Generally, people refer to it as an individual retirement account. An IRA offers investors a tax-advantaged way to build the value of their investments during their working years. A traditional IRA offers investors tax-deferred growth, while a Roth IRA offers investors tax-free growth and withdrawals, after paying taxes on the money contributed.

Traditional IRAs, Roth IRAs, and SEP IRAs are three types of individual retirement accounts. In some ways, they're similar. Yet, there are some key differences in how they work, which can make one type better than another, depending on your goals and tax situation.

This article provides the basics for all three IRAs to help investors get started on their retirement savings journeys.

Traditional IRAs

A traditional IRA allows you to contribute pre-tax income to investments of your choice. Your money then grows tax deferred until you withdraw it in retirement. Many workers also roll the funds from their 401(k) or other company retirement plans into traditional IRAs when they retire or change employers.

Deductions

You can take a tax deduction for your contributions to a traditional IRA, provided your income falls below certain limits and you (and your spouse) meet the other eligibility requirements. If you have a workplace retirement plan your deduction will likely be limited if not eliminated. That means that you'll reduce your taxable income by the amount that you can contribute.

Withdrawals

When you withdraw money from the account, typically in retirement, it will be taxed as ordinary income (when you may be in a lower tax bracket). Bear in mind that you can access your funds at any time, but you'll face financial penalties for doing so before age 59½.

Limits

The money in a traditional IRA can't grow tax-deferred forever. The Setting Every Community Up for Retirement Enhancement Act (SECURE Act) in December 2019 raised the maximum age at which you must begin taking the IRS's required minimum distributions (RMD) each year to 72 (from 70 1/2).

SECURE 2.0 in December 2022, increased the age further. Now, if you were born between 1951 and 1959, you must begin taking RMDs at 73. If you were born in 1960 or after, you must begin at 75. The amount you must take is determined according to a formula based on your yearly account balance and a life-expectancy factor determined by the IRS.

Traditional IRA contributions are capped at $6,500 a year for 2023, with the option of an additional $1,000 catch-up contribution if you're 50 or older, for a total of $7,500. For 2024, the cap is $500 higher at $7,000, and $8000 for those 50 and older.

If you don't have a workplace-sponsored retirement plan, or if you think you'll be in a lower tax bracket after you retire than the one you're in now, a traditional IRA can be a good savings option.

Roth IRAs

The Roth IRA was introduced in 1997.

However, contributions are not tax deductible. With Roth IRAs, investors get their tax break on the back end. They pay no taxes on money withdrawn from their accounts.

For that reason, Roth IRAs are an attractive option for working people who expect to be in a higher tax bracket after they retire than they were in while working.

Another positive feature is that, unlike traditional IRAs, Roths aren't subject to required minimum distributions during your lifetime. So, if you don't need the money in your Roth IRA for living expenses, it can pass to your heirs when the time comes.

Roth IRAs have their own eligibility requirements. If your income exceeds a certain level, you won't be able to contribute to one.

Married Couples Filing Jointly

For 2023 contributions:

• If you make less than $218,000, you can contribute up to the allowed limit.
• If you make $218,000 but less than $228,000, your allowed contribution will be reduced.
• If you make $228,000 or more, you may not contribute to a Roth IRA.

For 2024 contributions:

• If you make less than $230,000, you can contribute up to the allowed limit.
• If you make $230,000 but less than $240,000, your allowed contribution will be reduced.
• If you make $240,000 or more, you may not contribute to a Roth IRA.

For Single Filers and Heads of Household

For 2023 contributions:

• If you make less than $138,000, you can contribute up to the allowed limit.
• If you make $138,000 but less than $153,000, your allowed contribution will be reduced.
• If you make $153,000 or more, you may not contribute to a Roth IRA.

For 2024 contributions:

• If you make less than $146,000, you can contribute up to the allowed limit.
• If you make $146,000 but less than $161,000, your allowed contribution will be reduced.
• If you make $161,000 or more, you may not contribute to a Roth IRA.

Reducing Contributions

To determine how much a contribution must be reduced (if your annual income is over the thresholds as mentioned earlier), the IRS provides this formula, which is detailed in Publication 590-A, available from the IRS website:

1. Determine your modified adjusted gross income (MAGI).
2. Subtract the following from your MAGI:
3. $218,000 (2023) or $230,000 (2024) if filing a joint return or as a qualifying widow(er), or
4. $0 if married filing a separate return, and you lived with your spouse at any time during the year, or
5. $138,000 (2023) or 146,000 (2024) for all other individuals   
6. Divide the result by $15,000 (use $10,000 if you're filing a joint return, are a qualifying widow(er), or are married filing a separate return and you lived with your spouse at any time during the year).
7. Multiply this result by the maximum contribution limit (in 2023, $6,500 or $7,500 if you're 50 or older) or (in 2024, $7,000 or $8,000 if you're $50 or older).
8. Subtract the result from the maximum contribution limit. This is your reduced contribution limit.

For example, if you are married filing jointly, over 50 (a limit of $7,500), and have a MAGI of $224,000, your reduction calculation would look like this (in 2023):

• $224,000 - $218,000 = $6,000
• $6,000 / $10,000 = 0.6
• 0.6 x $7,500 = $4,500
• $7,500 - $4,500 = $3,000

So, your contribution limit with these criteria is $3,000.

For example, if you are married filing jointly in 2024, over 50 (a limit of $8,000), and have a MAGI of $235,000, your reduction calculation would look like this:

• $235,000 - $230,000 = $5,000
• $6,000 / $10,000 = 0.5
• 0.5 x $8,000 = $4,000
• $8,000 - $4,000 = $4,000

So, your contribution limit with these criteria is $4,000.

SEP IRAs

A simplified employee pension (SEP) IRA is a type of individual retirement account that a business owner can open. The SEP IRA allows small employers to provide a basic retirement plan for themselves and their employees, if any, without the cost and complexity of a 401(k) or similar plan. In addition, employers can take a tax deduction for their contributions, much like a traditional IRA.

An advantage of the SEP IRA, if you have self-employment income to fund it, is that it has much higher contribution limits than a traditional or Roth IRA. You can contribute up to 25% of your compensation or $66,000 for 2023, whichever is less. In 2024, you can contribute up to $69,000.

As with a traditional IRA, withdrawals from a SEP IRA are taxed as ordinary income in retirement, and required minimum distribution rules apply.

IRA Differences

The table below outlines the key differences between the three retirement accounts.

The Bottom Line

Each of these types of IRAs fits a different profile. Take the time to determine which ones you qualify for and what serves your needs the most. Regardless of which you choose, it's always best to start saving early to take advantage of compounding so that you can ensure a comfortable retirement.