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401(k) vs. IRA - Should You Pick One or Have Both Retirement Accounts?

Not sure if you should use a 401(k) or an IRA? Money Girl tells you how to prioritize retirement accounts and pitfalls to avoid when you contribute to multiple types in the same year.

By
Laura Adams, MBA,
Episode #604
401(k) vs. IRA--Should You Pick One or Have Both Retirement Accounts?

Using one or more retirement accounts is one of the best ways to save more money and cut your taxes. But these special, tax-advantaged accounts can also be confusing because they come loaded with rules created by the IRS.

A common question is whether you can or should contribute to both a 401(k) and an IRA. In some cases, having more than one retirement account changes the benefits you receive. So, no matter whether you work for a company that offers a 401(k) or you’re self-employed with a solo 401(k) or a SEP-IRA, it can be a dilemma.

Leveraging a variety of options simultaneously allows you to invest as much as possible, but there are critical pitfalls to avoid. I’ll help you understand the advantages and disadvantages of contributing to multiple types of retirement accounts in the same year.

Can You Contribute to a 401(k) and an IRA in the Same Year?

Many people don’t realize that you can contribute to a 401(k) or a 403(b) and an IRA in the same year. For 2019, you’re allowed to contribute up to $19,000, or $25,000 if you’re over age 50, to most types of workplace retirement accounts.

The IRA contribution limits are $6,000 for either a traditional IRA, a Roth IRA, or a combination of both. And if you’re over 50, you can contribute an additional $1,000, for a total of $7,000.

In theory, you could max out both accounts by contributing a total of $25,000 ($19,000 plus $6,000) if you’re younger than 50. If you’re older, you could save up to $32,000 ($25,000 plus $7,000). 

In general, you must have earned income to qualify for an IRA, and you can’t contribute more than you earn for the year. But if you’re married and file taxes jointly and one of you doesn’t work, the working spouse can make contributions on behalf of the non-working spouse.

See also: How to Make Kids Rich by Investing in an IRA

How to Choose Between a Traditional and a Roth Retirement Account

If you have access to a traditional or a Roth 401(k) at work and are considering making contributions to a traditional or Roth IRA, which type(s) should you choose? What’s best for you depends on various factors, such as:

  • your income 
  • what’s offered by your employer 
  • whether you have self-employment income 
  • how you plan to use the money 
  • whether you want an upfront tax deduction 
  • what your future tax rate could be

traditional retirement account, such as an IRA or regular 401(k), allows your account to grow tax-deferred. You skip paying tax on contributions and investment earnings until you take withdrawals in the future.

You generally can’t withdraw funds until you reach age 59½ without paying income tax plus a 10% early withdrawal penalty. But you must begin taking withdrawals after you turn 70½ unless you have a workplace retirement plan and are still working. 

Roth retirement account, such as a Roth IRA or a Roth 401(k), allows your account to grow tax-free. You do pay tax upfront on contributions, but you get tax-free withdrawals of contributions and earnings if you’ve owned the account for at least five years.

With a Roth, you’re never required to take withdrawals. You can contribute after age 70½ so your account can grow tax-free for your entire life. The only limitation is that if you exceed an annual income threshold, you become ineligible to make contributions to a Roth IRA. But that restriction doesn’t apply to a Roth plan at work.

The only limitation is that if you exceed an annual income threshold, you become ineligible to make contributions to a Roth IRA. But that restriction doesn’t apply to a Roth plan at work.

To know whether a traditional or Roth is best, answer these three questions:

1. What’s my current income?

As I mentioned, there are annual income limits to qualify for a Roth IRA (but not for any Roth workplace plan).

Here are the limits for modified adjusted gross income (MAGI) that prevent you from contributing to a Roth IRA for 2019:

  • Single taxpayers are not eligible when MAGI is at or above $137,000. 
  • Married taxpayers who file a joint return are not eligible when household MAGI is $203,000 or higher. 

Let’s say you already own a Roth IRA, and your income goes up and exceeds the annual allowable limit. If that happens, it’s not a problem; you can continue to own and manage the account with no penalty, but you can’t add new funds to it.

On the other hand, as I mentioned, there is no income limit to qualify for a Roth account at work. So, you can have one no matter if you’re in an entry-level job or happen to be the highest-paid employee in the company.

2. Is my tax rate likely to go up in retirement?

As I previously mentioned, with any traditional retirement account, you get a break by delaying taxes until you take withdrawals in retirement. Roth accounts work the exact opposite way. With a Roth, you pay tax upfront, and then have no tax on withdrawals in retirement.

To pay as little tax as possible, consider whether your income tax rate could be lower now relative to when you retire. If you believe that you’ll be in the same or a higher tax bracket in retirement, choosing a Roth IRA or a Roth at work, if available is best. Paying tax on Roth contributions upfront at a lower rate saves you money.

Paying tax on Roth contributions upfront at a lower rate saves you money.

No one knows what will happen in the future, especially if you’ve got a long way to go until retirement. So, if you’re not sure about your tax rates, another tip is to diversify by having both traditional and Roth accounts. That way you’ll have taxable and non-taxable money to spend in retirement.

For instance, you could put half your contributions in a traditional 401(k) and half in a Roth 401(k). Or you might have a traditional retirement plan at work and a Roth IRA on your own if you’re eligible.

3. Do I want the most flexibility to tap the account early?

Taking an early withdrawal from a retirement account before you reach the official retirement age of 59½ typically means you must pay income tax plus a 10% penalty on the withdrawn amount.

However, Roth accounts give you the most flexibility when it comes to getting early access to your money. Since Roth contributions are made on an after-tax basis, you can withdraw original contributions without owing taxes or a penalty, no matter your age. However, withdrawals of earnings are subject to taxes and the penalty.

Remember that a 401(k), IRA, or any retirement account itself, is not an investment—it’s just a special type of account. It’s like an umbrella that shelters what’s underneath from taxes.

Remember that a 401(k), IRA, or any retirement account itself is not an investment—it’s just a special type of account. It’s like an umbrella that shelters what’s underneath from taxes.

For a summary of all the rules for using different retirement accounts, click here to download the free Retirement Account Comparison Chart PDF

Deducting Contributions to a Traditional IRA When You Have a 401(k)

While you’re allowed to contribute to both a workplace plan and an IRA, there’s a tax issue that can trip you up if you’re not aware of it. Problem is, if you or a spouse participate in a retirement plan at work, the tax deduction for traditional IRA contributions may be reduced or eliminated, depending on your income.

Here are the 2019 income limits when deductible contributions to a traditional IRA are reduced or eliminated:

  • Single taxpayers get a partial deduction when you have MAGI between $64,000 and $74,000, but no deduction at or above $74,000. 
  • Married taxpayers who file a joint return get a partial deduction when household MAGI is between $103,000 and $123,000, but no deduction at or above $123,000. 

If you earn less than $64,000 as a single or $103,000 as a joint filer, you can deduct all of your traditional IRA contributions even if you have a retirement plan at work.

Deducting Contributions to a Traditional IRA When Your Spouse Has a 401(k)

And if that rule wasn’t enough, there’s another one that affects married folks. Let’s say you work for a small company that doesn’t offer a retirement plan, but your spouse has a 401(k). Because your spouse has a 401(k), that may limit the deductibility of your IRA depending on your household income.

For 2019, married taxpayers who file a joint return get a partial deduction when their household MAGI is between $193,000 and $203,000, but no deduction at or above $203,000. Again, this limit only applies when you don’t have a workplace plan, but your spouse does, and you contribute to an IRA.

Remember that you can contribute to a traditional IRA no matter your situation. However, these income limits that I’ve reviewed determine the amounts you may be able to deduct from your taxable income. Any contributions that don’t qualify for a tax deduction get categorized as non-deductible contributions.

If neither you nor your spouse has a retirement plan at your work or business, you can deduct your traditional IRA contributions.

See also: 10 Pros and Cons of 401(k) Loans You Should Know

Should You Make Non-Deductible Contributions to a Traditional IRA?

You might be thinking, what’s the point of making non-deductible contributions to a traditional IRA that don’t come with a tax break? The benefit is that even those non-deductible contributions can grow in the account and are not taxed until you make withdrawals in the future. So, having tax deferral is still a great way to cut your taxes in the current year.

Having tax deferral is still a great way to cut your taxes in the current year.

But a downside to having a traditional IRA that contains both deductible and non-deductible contributions is that the recordkeeping gets tricky. So, if you’re not either extremely organized or using an accountant, open a separate traditional IRA that’s just for your non-deductible contributions.

Separating different types of IRA contributions helps prevent any confusion about which funds have already been taxed and which haven’t when you withdraw them in the future. If you or your custodian don’t keep this straight, you could end up paying tax on the same funds for the second time in retirement.

To help with the recordkeeping, you’re required to file IRS Form 8606, Nondeductible IRAs when you make non-deductible contributions to a traditional IRA.

Making Roth IRA Contributions When You Have a 401(k)

Since Roth IRA contributions are not deductible, there’s never conflict with having one in addition to a workplace account. They complement a retirement plan at work very well.

However, as I previously mentioned, not everyone qualifies for a Roth IRA. If you make over a certain amount of income, you’re not allowed to contribute. But if your income is below the threshold for your tax filing status and you have a retirement plan at work, contributing to a Roth IRA is a terrific option.

Should You Invest in a 401(k) or IRA First?

Using retirement accounts should be a cornerstone of your financial plan. But knowing how to prioritize them can be confusing.

If you have a retirement plan at work, that’s where I recommend you save for retirement first, especially if your employer offers a match. Those free matching funds are too good to pass up, so always contribute at least enough to max out what your employer will provide. Plus, it allows you to contribute triple what you can for an IRA.

But if you don’t have a 401(k), or you max out a workplace retirement plan, taking advantage of an IRA is a smart way to secure your financial future.

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