This question about comes up frequently: can I contribute to a 401k and an IRA? Fortunately for your retirement nest egg, you can contribute to both types of retirement accounts. In fact, both workplace and individual retirement accounts represent important building blocks in building your retirement savings. Supplementing your workplace retirement account is a great way to boost your retirement savings and put even more of your money to work in tax-advantaged accounts.
An added bonus: IRAs also often offer more investment options than the typical 401k plan. Just as with your traditional 401k, you contribute pretax dollars to a traditional IRA (as I discuss further, you can only contribute pretax dollars up to certain income levels) and then benefit from tax-deferred growth and distributions.
Contribution Limits For A 401k And An IRA
While contributing to both a 401k and IRA is certainly allowed, there are a few considerations to keep in mind. The first is the contribution limits the IRS places on each type of account, which are outlined in the table below.
Remember that contribution limits apply to the total of your contributions to all of your retirement accounts, either IRA or 401k. Note that the chart below includes the Roth option – which as of 2006 has been available for 401ks as well as IRAs. To read about how to decide between a Roth and a traditional account, see the Personal Capital blog post on “going Roth.”
Paying attention to these limits is important. If you do contribute more to your IRA accounts than is allowed, you’ll face a penalty in the form of a 6% tax on the excess contributions for each year they remain in the account. Putting too much into a 401k is unlikely because most plan administrators won’t allow it. However, if it does happen, you have until April 15th of the following year to remove the excess funds. If you miss that deadline, you’ll essentially be taxed twice on that money – once when you contribute it, and then you’ll pay tax on those funds again when you withdraw them.
IRA Deduction Limits
If you save with both a 401k and a traditional IRA, you may also face some limits on your ability to deduct your contributions depending on your income. Contributions to a Roth are never deductible.
For instance, if you are covered by a retirement plan at work:
- You can deduct up to the contribution limit, if you’re single and your modified AGI is $60,000. And you can take a partial deduction if your income is between $60,000 and $70,000. There’s no deduction for people who earn more.
- If you’re married and filing jointly, you can deduct the full amount if your modified AGI is $96,000 or less. You can take a partial deduction if your income is between that and $116,000. There’s not deduction if you earn more.
Deducting your contributions is always an added bonus, but keep in mind even if you’re above the limit that you’re still reaping the rewards of the IRA’s tax-deferred growth.
Examples Of How You Can Contribute To Both A 401k And An IRA
Let’s look at an example of how you can combine the power of the 401ks and IRAs to speed up your retirement savings:
Example #1: Consider a 30-year-old earning $55,000 per year (25% tax bracket). Her first priority should be saving at least enough in her workplace retirement plan to earn the full employer match, which in her case is 50% of the first 6% saved (a typical match scenario).
In this case, she’s saving nearly $5,000 in tax-deferred funds in her 401k ($3,300 + $1,650 match). However, perhaps she’s anticipating earning far more in the near future and wants to sock away some after-tax money while she’s still in a relatively low tax bracket. She could save an additional $5,500 in a traditional IRA. That brings her total annual contributions to $10,500, all of it growing in tax-advantaged accounts.
Example #2: Consider a 23-year-old at the beginning of her career who only makes $35,000 a year. She contributes 5% of her gross salary into a 401k ($1,750) and receives a one-for-one match up to $5,000. At the end of the year, she gets a $3,000 bonus and decides to also contribute to a Roth IRA instead of a traditional IRA or a 401k for tax diversification purposes.
She speaks to her mentor who mentions that because she’s only in the 15% tax bracket, it’s better to contribute to a Roth IRA and pay taxes up front, rather than differ paying taxes until she is 59.5 because she could very well be in a higher tax bracket. In total, she saves $3,500 in her 401k and $3,000 in her Roth IRA.
Example #3: Finally, consider a married 55-year-old man earning $280,000 per year. Say he’s maxing out his workplace 401k at his $17,500 yearly contribution limit. Because he’s over 50, he also gets to make a catch-up contribution of $5,500 to his 401k. Luckily for him, his work matches contributions one-for-one up to 6% of his salary – which means another $16,800 in his 401k, for a total of $39,800 that is pre-tax and will grow tax-free.
While he can also contribute $6,500 to a traditional IRA, his contributions will be nondeductible given his modified AGI level. The savings will still grow tax-free, so he decides it’s still a worthwhile retirement savings vehicle to pursue, despite the fact that it’s tied up for the next 4.5 years.
Retirement Contributions Add Up Over Time
Based on the above chart, you can see how one’s 401k savings can really start adding up over time. The low end assumes a consistent maximum contribution of $17,500 after the first year contribution of $8,000 with zero company match and zero growth. The high end column assumes a consistent maximum contribution of $17,500 plus a 5%-10% annual rate of return with zero company match.
So whether you’re looking for additional tax deductions or just a way to boost your savings, talk to your Personal Capital financial advisor about opening an IRA in addition to your workplace 401k. Once you retire, you’ll be glad you saved for all those years.
Photo credit: Steven Depolo