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Can a Simplified Employee Pension (SEP) Be Converted to a Roth IRA?

You can convert a Simplified Employee Pension (SEP) to a Roth IRA. As you may know if you already have a SEP IRA, it is just a traditional IRA that an employer or a self-employed person establishes. Except for allowable contribution amounts, it operates basically as an individual IRA does.

As with any Roth IRA conversion, you’ll need to follow Internal Revenue Service (IRS) rules. You’ll owe taxes on the amount converted in the year that the conversion takes place.

In this article, we cover some of the basics of a conversion as well as some of the key considerations if you’re thinking of making the switch.

Key Takeaways

  • A Simplified Employee Pension individual retirement account is a traditional IRA that is designed for small business owners and the self-employed.
  • You can convert your SEP account to a Roth IRA the same way you would any other IRA.
  • You will owe income taxes for that tax year on the entire balance since you’re rolling over funds from an account funded with pre-tax dollars to one funded with after-tax dollars offering tax-free withdrawals.
  • Your IRA trustee can oversee the conversion process for you from beginning to end.
  • If you elect to receive a check and fund the account yourself, you must do so within 60 days, or the amount will count as a distribution.

Understanding the SEP IRA

Like a traditional IRA, you can open a SEP IRA at just about any bank or financial institution. There are also a variety of investment options available to fund your account. Earnings grow on a tax-deferred basis and withdrawals are taxable as ordinary income when you retire.

A variation of the traditional IRA, the SEP IRA is designed for small businesses and those who are self-employed. With a SEP IRA, employers make tax-deductible contributions on behalf of eligible employees. An employee cannot contribute to their SEP-IRA. If you are self-employed, you are both the employer and the employee, which means you’re able to fund your own account.

This SEP IRA is intended to be easy to set up and flexible to use. An employer can decide at the end of the year whether or not to make a contribution. They can also decide how much to contribute.

An employer who contributes to their own account must also contribute to every eligible employee’s account. SEP IRAs have higher annual contribution limits than traditional and Roth IRAs.

You must have earned income or what the IRS calls taxable compensation to contribute to a Roth IRA.

Converting a SEP IRA to a Roth IRA

Making the conversion from a SEP IRA to a Roth account isn’t as difficult as you may think. However, there are a few things you should consider before you make the switch. We’ve highlighted some of the key considerations below.

Taxes Owed Upon Conversion

Just as with a traditional IRA, contributions to a SEP IRA are made with pre-tax earnings and are tax-deductible. When a SEP IRA account holder withdraws their money in retirement, they owe taxes on the withdrawn amounts.

With a Roth IRA, contributions are made with after-tax earnings (earnings that have already been taxed) so there’s no immediate tax break. However—and this is the Roth’s major benefit—you’ll owe no taxes on money that you begin withdrawing after the age of 59½.

Therefore, when you convert a SEP IRA to a Roth IRA, you’ll pay taxes on the balance that you convert in the tax year that you convert it. In other words, you’ll pay the tax you’d normally owe on a distribution from an IRA. Then, the money that goes into your new Roth IRA will be an after-tax contribution, as required by all Roth IRAs.

How much tax you pay will depend on your tax bracket and the amount you convert (which is taxed as ordinary income). If your annual income is high, you’ll be subject to a higher tax rate on the rollover amount.

Distributions

Another benefit of the Roth IRA is that you are not required to make annual withdrawals. These withdrawals are called required minimum distributions (RMDs). RMDs are the government’s way of ensuring it gets the tax revenue that it’s waited for over the years. It also prevents taxpayers from growing their tax-deferred retirement plan balances indefinitely.

You must begin taking RMDs from your retirement accounts by April 1 after the year you turn 72. The age threshold for taking RMDs was changed in 2020. Prior to that year, investors had to start taking withdrawals at age 70½.

To determine the RMD amount, you can you can use a worksheet provided by the IRS. The formula involves dividing the fair market value (FMV) of your account at the end of the prior year by the life expectancy or total distribution period. Typically, though, your RMDs will be calculated by your account custodian or trustee.

Early-Withdrawal Penalties

Any time you make a withdrawal from a retirement account before it’s allowed (at age of 59½), the IRS imposes an early withdrawal penalty. That penalty is 10% of the withdrawn amount. Keep in mind that this penalty is in addition to the taxes you will owe on the withdrawal.

There are exceptions to the early-withdrawal rule. For instance, anyone who takes money from their account(s) for qualified tuition expenses for themselves, their spouse, or a dependent is exempt from any tax-related penalties. Additionally, qualified taxpayers can withdraw up to $10,000 from their IRA accounts to purchase their first homes.

Converting a SEP IRA to a Roth IRA can be a sound retirement planning strategy if you can afford to pay the taxes now. This is especially true if you expect to be in a higher tax bracket after you retire.

How to Convert a SEP to a Roth IRA

Contact the financial institution that manages your SEP IRA to start the process of converting your account to a Roth IRA. This is the trustee for the account. You can rollover the money into a Roth IRA account at that institution or somewhere else, if you choose.

The most straightforward way to convert to a Roth IRA is to request that the trustee transfer the funds to the Roth IRA directly. This is what the IRS calls a trustee-to-trustee transfer, since the financial institution holding your SEP IRA makes the payment directly from that account to the financial institution holding the new Roth IRA.

It’s more complicated to have the funds paid directly to you. This means that a check is made out to your name and sent to you. Once you receive the check, if you don’t deposit it to the new Roth IRA within 60 days, it counts as a distribution. You’ll owe taxes—plus an early withdrawal penalty of 10% if you’re under the age of 59½.

Should I Convert My SEP IRA to a Roth IRA?

That depends. Converting your SEP IRA to a Roth account triggers a taxable event. That’s because you’re rolling money from an account that was funded by pre-tax dollars to an account that is funded with after-tax dollars. So you’ll owe taxes on your conversion amount. Having said that, rolling a SEP IRA into a Roth IRA can be a good choice if you’re able to afford to pay the associated taxes. Of course, a Roth IRA can be a great idea if you’ll be in a higher tax bracket during retirement. However, it makes all round good sense for any retiree in any tax bracket who simply wants to cut the taxes they pay in their later years.

What Is a Roth Individual Retirement Account Conversion?

A Roth individual retirement account (IRA) conversion takes place when retirement funds from either a traditional IRA, including a Simplified Employee Plan (SEP) IRA, or a 401(k) are transferred into a Roth account. You’ll pay tax on the money converted, but withdrawals from the Roth IRA are tax free when you reach age 59½.

How Much Is the Early Withdrawal Penalty?

The early withdrawal penalty for Roth and traditional IRAs is 10% of the amount that you withdraw before age 59½. You will also owe income tax. You can withdraw contributions (but not earnings) at any time from a Roth IRA without being subject to the penalty or tax.

How Much Can I Contribute to My Roth IRA?

The Bottom Line

Converting a SEP IRA to a Roth IRA is fairly simple and straightforward. Just contact your account custodian or trustee and request it. You’ll face the same taxable event that results from converting from a traditional IRA to a Roth IRA.

Should you make the switch? That depends. It may make sense if you expect to be in a higher tax bracket when you retire and want to benefit from the tax-free withdrawals that Roth IRAs provide. You also won’t be subject to required minimum distributions.

Correction—Sept. 17, 2022: A previous version of this article misstated that SEP IRA and personal IRA contributions are made with after-tax dollars.

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