December 4, 2023

SEP IRA to Roth IRA Conversion - Avoiding Taxes & Penalties


The SEP IRA is a retirement savings plan for small businesses. It allows employers to contribute to a retirement account on behalf of its employers and the business owner, providing immediate tax benefits and the opportunity for long-term savings growth.

One of the primary benefits of a SEP IRA is the ability to deduct contributions as a business expense. The contributions reduce taxable income in the year of the contribution. As an additional benefit, you can transfer pre-tax SEP IRA contributions and accumulated earnings into a Roth IRA account (called a “conversion). 

Because a Roth IRA is an after-tax account, a conversion creates taxable income in the year of the conversion year but the converted amount appreciates tax-free within the Roth IRA until retirement, when it can also be withdrawn tax-free.

By strategically timing the conversion in years when you’re subject to a lower tax rate relative to your retirement years, you can shift taxable income from a higher tax bracket to a lower tax bracket. 

However, missteps in the conversion process can lead to early withdrawal penalties, making it essential to understand the specific regulations and tax implications involved before executing the conversion.

SEP IRAs - The Basics

A Simplified Employee Pension Individual Retirement Account (SEP IRA) is a retirement savings plan tailored for small business owners and self-employed individuals. It allows business owners to make tax-advantaged contributions towards retirement savings for themselves and their employees. 

SEP IRAs are known for their ease of setup and administration, making them an attractive option for small business owners. They provide a straightforward way for employers to contribute towards their own and their employees' retirement savings accounts, with higher contribution limits compared to traditional and Roth IRAs.

Tax Benefits of a SEP IRA

Contributions to a SEP IRA are deductible for the business, reducing taxable income. Earnings in the employee’s or business owner’s SEP IRA grow tax-deferred until withdrawals during retirement.

Compared to Traditional IRAs, which offer similar tax benefits, SEP IRAs allow for a larger contribution since the maximum contribution is based on an employee’s salary rather than a fixed annual limit. For self-employed individuals filing on Schedule C, the max contribution is based on net business income.

Opening a SEP IRA

To establish a SEP IRA, an employer must implement a formal written agreement specifying which employees are eligible for the plan, notify employees that a plan has been implemented, and help eligible employees set up their individual SEP IRA accounts.

Contributing to a SEP IRA

Contributions to a SEP IRA are made solely by the employer, not the employees. This distinguishes it from other retirement plans where employees can also contribute. When making contributions, the pro-rata rule requires equal percentages of salary to be contributed to all eligible employees’ SEP IRAs.

SEP IRA Limits & Due Dates

The contribution to each employee’s account is limited to the lesser of (a) 25% of an employee’s compensation or (b) the maximum amount set annually by the IRS. Contributions must be made by the employer’s tax filing deadline, including extensions.

SEP IRA to Roth IRA Conversion - Overview

A SEP IRA to Roth IRA conversion involves transferring funds from a SEP IRA, a pre-tax retirement account, to an after-tax retirement account, such as a Roth IRA. 

The conversion changes the character of the transferred funds from pre-tax to after-tax. Contributions to a SEP IRA are tax-deductible, whereas the funds transferred into a Roth IRA will be taxed when converted. 

The amount converted will appreciate within the Roth IRA tax-free and withdrawals from the Roth IRA made in retirement are also tax-free.

Tax Consequences of a Roth IRA Conversion

Since SEP IRA contributions are made pre-tax, converting funds from a SEP IRA to a Roth IRA triggers a taxable rollover distribution. Subsequently rolling over the distribution into a Roth IRA (an after-tax account) isn’t deductible so you must pay taxes on the initial rollover distribution. 

The taxable amount includes both the contributions made to the SEP IRA and any earnings on those contributions. The taxes owed are based on your current income tax rate for the conversion year.

Roth Conversion - Early Withdrawal Penalties

An important consideration in the conversion process is the potential for a 10% early withdrawal penalty. To avoid penalties, it’s important to be mindful of the following rules when undergoing the conversion process:

  1. Income Tax Withholdings on Rollover Amount - If you’re under the age of 59½ and choose to withhold taxes during the conversion (thus reducing the amount transferred to the Roth IRA), the withheld taxes get sent to the IRS and not to the Roth IRA, making the withheld amount subject to a 10% early withdrawal penalty. To avoid this penalty, it is generally advisable to pay any taxes due on the conversion with funds outside of your SEP IRA.
  2. Funds Not Deposited within 60 Days - Additionally, if the SEP IRA custodian sends the funds to you instead of directly to the Roth IRA custodian, your failure to deposit the funds into the Roth IRA within 60 days of receipt will make the entire distribution subject to early withdrawal penalties. You should have the custodian transfer funds directly to the Roth IRA, if possible.

The early withdrawal penalty will be calculated when filing your personal tax return the following year. In certain situations, such as when the financial institution mishandles the funds, you can have the penalty waived. Nevertheless it’s important to gain a proactive understanding of the conversion process to avoid surprises when filing your tax return.

Roth IRA Conversions - Pros & Cons

The benefits of a Roth conversion depend on your financial circumstances, including the amount and character of income you anticipate during retirement, your income in the current year, and your long-term savings goals.

Benefits of a Roth Conversion

The primary motivation for pursuing a Roth conversion is to move pre-tax funds, such as those held in a SEP IRA, into an after-tax retirement account, such as a Roth IRA 

Roth IRAs are subject to different tax rules than SEP IRAs are. The most significant difference is that earnings in a Roth IRA grow tax-free. Unlike a SEP IRA, where withdrawals are taxed as income, qualified distributions from a Roth IRA are tax-free. This includes both the original contributions and any earnings on those contributions.

Bypass Roth IRA Income & Contribution Limits

However, not everyone can contribute to a Roth IRA due to the income limits that dictate who is allowed to contribute to a Roth IRA. Taxpayers earning above these limits aren’t eligible to directly contribute to a Roth IRA.

As an alternative, business owners who otherwise can’t contribute to a Roth IRA can first contribute to a SEP IRA and later convert the funds, bypassing the income limits for contributing to a Roth IRA.

Furthermore, since the maximum SEP IRA contribution is based on salary or business income, a SEP IRA converted to a Roth IRA often provides for a larger after-tax contribution than a direct Roth IRA contribution would ordinarily provide.

Shift Income to Low-Tax Years

In addition to bypassing the income and contribution limits, the primary benefit of a Roth conversion is the flexibility to shift income from a higher tax bracket to a lower tax bracket. This is accomplished by converting funds from a pre-tax account (i.e. the SEP IRA) to an after-tax account (i.e. the Roth IRA) during a year of relatively lower income as compared to your retirement years. 

By transferring funds from a SEP IRA to a Roth IRA, you’ll pay taxes on retirement income in the conversion year instead of when you withdraw the funds during retirement. 

Disadvantages of a Roth Conversion

The idea of tax-free retirement income is alluring, but it’s worth noting that a Roth conversion isn’t always beneficial.

For a variety of reasons, most individuals will have a lower cost of living during their retirement years as compared to their working years. Their children are often financially independent, their need to save for retirement is less, they move to less expensive geographies, they no longer commute to work, and other reasons.

The lower cost of living means that they can live comfortably on less income. They might also be receiving Social Security benefits that are either tax-free or subject to reduced tax rates. Their relatively low income provides low to zero tax rates on certain types of investment income. They also receive a larger standard deduction when filing their tax returns. 

Although contributions and earnings can be withdrawn from a Roth IRA tax-free during retirement, the likelihood of very low to zero tax rates make it entirely possible that income drawn from a Traditional IRA could also be tax-free.

Roth Conversions Have a Large Opportunity Cost

When executing a Roth conversion, you’ll pay taxes in the conversion year instead of the withdrawal year during retirement. The amount paid in taxes represents lost investment principal, since the tax liability could have been invested for use in other purposes, such as retirement and other financial goals. 

In this case, it might have been more advantageous to not do a Roth conversion, since the pre-tax distributions during retirement might have been subject to very little tax. Instead, you prepaid tax now and might end up paying more total tax than you otherwise would have.

In short, the tax deduction provided by a SEP IRA contribution in current years often outweighs the tax-free income in retirement years so it’s important to first compare your tax rates in the current year to the potential tax rates of your retirement years.

SEP IRA to Roth IRA Conversion Walkthrough

To avoid triggering an early distribution from your SEP IRA and the associated penalties, it’s important to carefully execute the Roth conversion. Here's how to navigate the conversion process penalty-free.

Initiating the Conversion

The conversion process is initiated through the financial institution that manages your SEP IRA, also known as the trustee. Depending on where your Roth IRA is held–at the same trustee or financial institution–the conversion can be facilitated in one of three ways:

  1. Indirect Rollover
  2. Trustee-to-Trustee Transfer
  3. Same-Trustee Transfer

Indirect Rollover

An indirect rollover occurs when the SEP IRA trustee sends you the conversion distribution instead of sending it to the Roth IRA trustee. You’re then responsible for depositing the distribution into the Roth IRA within 60 days of the distribution (the distribution check is payable to you). Failing to deposit the funds will result in a 10% early withdrawal penalty in addition to income taxes on the amount distributed (see “Rollovers”).

Indirect rollovers are also subject to a 20% income tax withholding rate. Since the withholdings aren’t actually rolled over (they’re sent to the IRS), the withholdings count as distributions subject to early withdrawal penalties.

Direct Rollovers

Direct rollovers include trustee-to-trustee and same-trustee transfers. Direct rollovers don’t involve you in the process of transferring funds. The trustee transfers funds directly into the Roth IRA or sends the conversion amount directly to the trustee administering your Roth IRA. 

Because you’re not involved in the distribution process, direct rollovers avoid triggering the 60-day window in which you must deposit a conversion distribution that was sent to your personal accounts. 

Furthermore, there is no mandatory tax withholding on direct rollovers so you’ll avoid inadvertently triggering an early withdrawal through tax withholding. The conversion itself is still taxable however, so consider making an estimated tax payment from other sources of income or savings during the conversion year.

Tips for Avoiding Early-Withdrawal Penalties

When executing a Roth conversion it’s possible to trigger early withdrawal penalties. These penalties generally apply when you take a distribution from the SEP IRA but fail to make a timely rollover contribution into the Roth IRA. Following the tips below will help you navigate the conversion process without incurring penalties:

  • Use a Trustee-to-Trustee or Same-Trustee Transfer - The safest way to avoid penalties is to opt for a trustee-to-trustee transfer, where the financial institution holding your SEP IRA directly transfers the funds to the Roth IRA. If your Roth and SEP IRA are at the same institution, you’ll use a same-trustee transfer. Either method minimizes the risk of accidental penalties since the funds are not distributed to you personally.
  • Adhere to the 60-Day Rollover Rule - If you receive the funds from your SEP IRA before they are deposited into a Roth IRA (via indirect rollover), it’s imperative to deposit the full amount into the Roth IRA within 60 days. Failing to do so could result in the amount being treated as a taxable distribution, with additional penalties if you are under the age of 59½.
  • Withhold Taxes Carefully - Be cautious about withholding taxes from the rollover amount. If taxes are withheld, the IRS may treat it as a distribution, subjecting it to early withdrawal penalties. To avoid this, consider paying any conversion taxes from other sources rather than the retirement funds themselves.
  • Monitor the Pro-Rata Rule - If you have both pre-tax and after-tax dollars in any traditional IRA, be aware of the pro-rata rule during conversion. This rule requires the inclusion of a proportional amount of pre-tax and after-tax funds in each conversion, which could affect the taxable amount and potential penalties.
  • Understand Conversion Taxation - Recognize that the conversion amount from a SEP IRA to a Roth IRA will be treated as taxable income. Ensure that this additional income doesn’t inadvertently increase your tax liability to a degree that could trigger other financial penalties or issues, such as the Underpayment of Estimated Tax penalty.

Strategically Timing the Roth IRA Conversion

The general rule is that you should execute a Roth conversion during a year of relatively lower income. The conversion can yield significant tax savings assuming your income will be greater in the conversion year than it will be during your retirement years. The tax savings are caused by the presumably lower income tax brackets you’ll be subject to during the conversion year.

Ideal candidates for a Roth conversion include:

  • Individuals with high earning potential who are starting their career; 
  • Mid-career professionals taking unpaid leave; 
  • High-earners moving to part-time work;
  • Business owners with a slow year of income

Since tax rates change and retirement savings rise and fall, knowing what your tax rate will be in retirement requires predicting the future. Perfectly timing a Roth conversion is therefore very hard to do. Even so, identifying years of low income relative to your expectations for income during retirement can be a reliable rule of thumb for timing the conversion.

Using a SEP IRA to Roth IRA Conversion to Shift Business Income

The timing of a Roth conversion is of particular importance for business owners who have multi-year fluctuations in income. Such individuals can use a Roth conversion to shift income from high-income years, when they’re subject to higher marginal tax rates, to low-income years later in the cycle.

Converting in a Subsequent Year

For example, deducting SEP IRA contributions in a boom year and converting them in a bust year would allow the boom year’s income to be taxed in a lower tax bracket when converted. When timing the conversion, you’d still want to consider your anticipated retirement income to confirm that the conversion will yield net tax savings.

Converting in the Same Year

Alternatively, contributing to a SEP IRA and converting the contribution in the same year can be advantageous if your income in that year will be relatively lower.  The conversion will be taxable but, assuming your retirement tax bracket will be lower, you’ll pay less overall tax on the contribution amount.

Tax Bracket Shifts in the Conversion Year

A large conversion could push you into a higher tax bracket, increasing the tax liability. Spreading out conversions over multiple years can help mitigate this risk.

Align the Conversion with Long-Term Financial Goals

Align the conversion strategy with your long-term financial goals. For example, if you aim for tax-free income in retirement or wish to leave a tax-free inheritance, converting to a Roth IRA aligns with these objectives. 

On the other hand, if you want to maximize after-tax income and invest the tax savings during pre-retirement years, then retaining funds in a pre-tax account such as a SEP IRA might make more sense.

Consult with a Professional

Given the complexities involved in the Roth conversion process and its long-term implications, consulting with a tax professional to chart your conversion strategy is highly advisable. Get in touch through the contact form below if you’d like to speak with a professional who can provide personalized advice based on your specific financial situation and goals.

This content is for informational purposes only and does not constitute legal, business, or tax advice. You should consult your own attorney, business advisor, or tax advisor regarding matters mentioned in this post. We take no responsibility for actions taken based on the information provided.

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