If you can’t max out both types of retirement accounts, you should prioritize saving enough in your 401(k) plan to qualify for the 401(k) match offered by your employer.(GETTY IMAGES)
Contributing to both types of retirement accounts can boost your savings and reduce your tax bill.
You can save for retirement in a 401(k) plan and an individual retirement account at the same time. Both types of retirement accounts allow you to defer paying income tax on your retirement savings, and contributing to a 401(k) and IRA could allow you to significantly reduce your tax bill. However, high earners may not be able to claim a tax deduction on contributions to both types of accounts in the same year.
Here’s how saving in a 401(k) and IRA can improve your retirement finances:
- Many people are eligible to save for retirement in a 401(k) plan and an IRA.
- You may be able to defer paying income tax on as much as $25,500 ($33,000 at 50 or older) if you max out both accounts.
- There are income limits for tax-deductible IRA contributions if you also have a 401(k) plan.
- Contributing to a 401(k) account and Roth IRA can help you manage your retirement tax bill.
Contribution Limits for 401(k)s and IRAs
Employees are eligible to defer paying income tax on up to $19,500 that they contribute to a 401(k) plan in 2021. Those age 50 and older can additionally make catch-up contributions of up to $6,500 for a total 401(k) contribution of $26,000. An employer may make additional contributions to the 401(k) plan on behalf of employees or provide matching funds.
IRAs have a much smaller contribution limit of $6,000, plus an additional $1,000 catch-up contribution for workers age 50 and older. Contributing to both types of accounts in the same year can allow you to defer income tax on as much as $25,500 if you are 49 or younger and $33,000 at age 50 or older.
The tax benefits of maxing out both a 401(k) and IRA can be significant. A worker in the 22% tax bracket who is able to contribute $33,000 to a 401(k) and IRA will reduce his current tax bill by $7,260. Income tax won’t be due on that money until it is withdrawn from the account.
Income Limits for Traditional IRA Contributions
Workers who don’t have access to a 401(k) account can make tax-deductible contributions to a traditional IRA regardless of how much they earn. Those who have a 401(k) at work can additionally save for retirement in a tax-deductible IRA unless their income exceeds certain limits.
Employees with a 401(k) account can’t claim a tax deduction for a 2021 IRA contribution if their income exceeds $76,000 as an individual and $125,000 as a married couple filing jointly. The IRA tax deduction is phased out for individuals earning more than $66,000 and couples earning more than $105,000. If only one member of a married couple has a 401(k) plan, the tax deduction is phased out when the couple’s income is between $198,000 and $208,000.
“Traditional IRA contributions may only be partially deductible or not deductible at all depending on a family’s income,” says Liz Sylvan, a certified financial planner for Cultivating Wealth in Brooklyn, New York. “That doesn’t mean a person can’t contribute. It just means they don’t get the benefit of a tax deduction for the contribution.”
Saving in a 401(k) and a Roth IRA
You can also save for retirement in a 401(k) and Roth IRA in the same year. An after-tax Roth IRA has higher income limits than a traditional IRA. Those who earn less than $140,000 as an individual and $208,000 as a married couple can make Roth IRA contributions in 2021. The contribution amount is phased out for those earning more than $125,000 as an individual and $198,000 as a married couple. The Roth IRA income limits apply regardless of whether you have a 401(k) at work, but there are some ways around them, such as using a backdoor Roth or mega backdoor Roth strategy.
Contributing to a Roth IRA won’t get you a tax break in the year you make the contribution, but you will be able to take tax-free withdrawals in retirement. Saving in a traditional 401(k) and a Roth IRA adds tax diversification to your portfolio. When you have a traditional and Roth retirement account, you get to decide how much to withdraw from a taxable account and tax-free account each year in retirement, which can help you manage your tax bill.
“A Roth IRA grows tax-free, and then you can really control your tax rate in retirement because if you withdraw from a traditional 401(k) and IRA that is taxed at your regular income tax rate and if you withdraw from a Roth it is tax-free,” says Tess Downing, a certified financial planner and founder of Complete View Financial in San Antonio.
How to Decide Where to Save
If you can’t max out both types of retirement accounts, prioritize saving enough in the 401(k) plan to qualify for a 401(k) match. After that, compare your 401(k) plan to an IRA to see which has better investment options and lower fees.
“I always encourage individuals to contribute up to their employer’s match in their 401(k),” says Kyle Hill, a certified financial planner and founder of Hill-Top Financial Planning in Kansas City, Missouri. “Then, go over and fund a Roth IRA. If you’re still looking to do more retirement savings after maxing out your Roth IRA, then go back to your 401(k) and contribute more to that.”