Can I contribute to both my employer's 401(k) and a traditional or Roth IRA? How do I make the most of my retirement savings with more than one account?
Contributing to retirement accounts can help you boost the tax efficiency of your retirement investments and potentially grow your wealth faster.
The good news is that you may have access to multiple paths, from an employer’s 401(k) plan (if one is available) to individual retirement accounts (IRAs). Consider making those contributions automatic and tailor your portfolio to your own risk tolerance and long-term strategy.
Taking advantage of an IRA and 401(k) sounds like great advice, but it may be confusing to decide exactly how to go about doing it all and which retirement-saving moves should take priority over others. Let’s look at one example of a three-step plan for contributing to both an IRA and 401(k) in a way that can potentially maximize multiple tax-advantaged retirement contributions. (Keep in mind that all investing involves risk, including the risk of loss of principal.)
Remember, however, that the rules in place today for 401(k) and IRA contribution limits are likely to change over the years. That said, here are three steps you can take to try to maximize your retirement savings plan across accounts and account types. Consider the following steps:
If your employer offers a 401(k) with a matching contribution, many financial advisors recommend you take advantage of it. An employer match on your contribution can be considered “free money,” and who wants to leave a freebie on the table?
The amount of matching funds you receive depends on what your employer offers. Often this contribution is tied to your longevity at the company and may be on a “vesting schedule,” which gives employees full ownership of their funds over time. Vesting schedules aim to provide a financial incentive to an employee to stay with a company.
So, it’s important to know the specifics of your company’s 401(k) contribution plan, including what percentage of your salary it will match and how long it may take for you to have the rights to those matching contributions.
There are no income restrictions for participating, but there are limits on how much you can contribute, according to the Internal Revenue Service (IRS):
Remember: Your employer’s matching contribution doesn’t count toward the annual limit. Consider contributing enough to at least get your company match. And if you get a raise or a bonus, you might want to earmark a portion to your retirement account.
The amount you contribute to a traditional 401(k) is taken out of your paycheck on a pretax basis, thereby reducing your taxable income. However, when you withdraw those funds, you’ll have to pay taxes on the full amount of the withdrawal, including gains. Alternatively, money deposited into a Roth 401(k) was already taxed as normal income, but you may withdraw those funds tax free, no matter how much you’ve made in gains.
When deciding between a traditional 401(k) or a Roth 401(k), the choice is between deferring the taxes until the money is withdrawn in retirement or paying federal taxes up front but never again. Keep in mind this reflects current conditions and could always change.
Can I have both a 401(k) and an IRA?
Say you’ve planned to contribute at least the maximum employer-matching amount to your 401(k). Now you might consider your next set of choices. You may want to continue contributing up to the contribution limit, or you may want to use an IRA, which would not be related to your place of employment like a 401(k) is.
Even if you contribute the maximum to a work-sponsored 401(k) or a similar plan, you may still be able to contribute the full amount to an IRA. However, if it’s a traditional IRA, such a contribution might not be tax deductible. If you have access to a workplace retirement plan, your deduction begins phasing out when your modified gross adjusted income (MAGI) reaches $66,000 for single filers and $105,000 for joint filers in 2021. You may want to consider speaking with a tax professional for your individual situation.
If you want to contribute to a Roth IRA, you must meet income requirements, with a MAGI limit of $140,000 for single filers and $208,000 for married filers in 2021.
Like a 401(k), IRAs offer one of two different tax advantages. Any contributions you make to a traditional IRA may be tax deductible depending on your modified adjusted gross income (MAGI). Roth IRAs, on the other hand, aren’t tax deductible immediately, but you may withdraw those funds (including any gains) tax free on qualified distributions during your retirement years.
However, if you earn over a certain amount, you may not be able to open a Roth IRA. Roth IRAs have an income threshold for contributions, but not one that’s bound by an employer’s retirement plan contributions. Contribution eligibility is determined by your MAGI.
Remember, you can never contribute more than your annual income. For example, if you earned $4,000, the most you can contribute to an IRA is that amount. Contributions for non-working spouses are based on the income of the working spouse.
Essentially, to decide whether a traditional IRA or Roth IRA is best for your retirement goals, learn about the tax consequences of each account. You may also want to consult a tax professional who understands your specific situation.
Again, traditional IRAs are tax deferred. That means you pay the taxes on the full amount, including interest or gains when the funds are withdrawn during retirement. Roth IRAs are funded with post-tax dollars, so you’re not taxed (even on account earnings) once the money comes back to you if the distribution is qualified.
Investors with longer time horizons often benefit from the long-term tax advantages of a Roth because investment gains can compound over time and more easily offset any taxes paid on the original contribution. And investors with shorter investing horizons or those who need the benefit of tax advantages immediately may prefer traditional IRAs.
Because they’re on separate sides of the tax spectrum, traditional and Roth IRAs can play off each other in retirement. Having a combination of taxable and tax-free income may help you create a withdrawal plan that might potentially minimize your tax bill.
You’ll need to start taking required minimum distributions from your traditional IRA once you turn 72, but this rule doesn’t apply to Roth IRAs. That means your money can stay invested longer.
There’s one caveat to owning and investing in more than one IRA: The annual limits on your contributions are cumulative between all IRAs you fund, not each individual one. You can split your contributions any way you want as long as you don’t exceed the annual limit and you meet the income rules. For example, if you contribute the full $6,000 to a traditional IRA, you can’t contribute to a Roth IRA in 2021. IRAs also come with catch-up contributions for those 50 and older, allowing you to add an extra $1,000 to your account in 2021.
Remember that pulling money out of your IRA and 401(k) early can be a pricey proposition:
Depending on what period of your life the funds are withdrawn from your IRA and 401(k), the opportunity costs of pulling money out early could put a big dent in your retirement nest egg because those assets are no longer growing tax deferred. Although there are exceptions, it’s important to understand them before you withdraw. Consider consulting with a knowledgeable retirement or tax professional before moving forward.
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