QUESTION: Monica has an incorporated business. She’s looking at putting some of her profits into IRAs or SEP IRAs. Is one better than the other?
ANSWER: A traditional, old-fashioned IRA allows you to put money in and take a tax deduction. Then your money grows tax-deferred and you don’t pay taxes on it till you pull the money out.
A Roth IRA is a tax-free growth IRA. You don’t get a tax deduction when you put the money in, but it grows tax-free.
For example, if a 30-year-old couple who each put $3,000 in a Roth IRA invest in good growth stock mutual funds, which have averaged 12% since inception, they’ll end up having $5.8 million if they do that to age 70. They won’t get a tax deduction on the $240,000 they put in over 40 years, but they will not have to pay taxes on the $5.8 million either.
If they put that in a traditional IRA for 40 years, they will have put in $240,000 for which they’ll get a tax deduction. They will also have to pay taxes on almost $6 million.
The SEP IRA is the Simplified Employment Pension plan for small business owners to invest up to 13.8% of their net profit. It works like a traditional IRA. You get the tax deduction, but it grows tax deferred.
You should fully fund the Roth IRA first – which is $8,000 this year for married couples – before you do a SEP. A SEP is a good plan for small business owners after fully funding the Roth.