A 401(k) AND an IRA? Financial Advisor in Annapolis Explains Why You’d Want Both
The most common types of retirement accounts are the 401(k) and the IRA, and as a financial advisor in Annapolis, we help clients decide which could be right for them. But what if we told you that the IRS allows you to have a 401(k) and an IRA? There are major advantages to having both.
The beauty of combining these two retirement savings vehicles is that they allow you to save more and offer a variety of tax advantages based on account type, both now and in the future. The investment flexibility offered by IRAs can also help diversify your retirement portfolio.
A 401(k) Versus an IRA
Both the 401(k) and the IRA allow you to save for retirement, but there are important differences between these two types of accounts.
A 401(k) is typically sponsored by an employer, and an employer often matches a certain percentage of employee contributions. You contribute pre-tax dollars directly from your paycheck to your Traditional 401(k), and earnings growing in your account aren’t subject to tax until you take funds out.
With a 401(k), you are able to contribute more – much more – annually than you are to an IRA.
However, because IRAs are not sponsored by an employer, they can give you more flexibility with investment options, including stocks, bonds and mutual funds. With a Traditional IRA, you don’t pay income tax on contributions or earnings, but on withdrawals. Roth IRAs are the opposite – withdrawals in retirement are tax-free because you pay taxes on the money at the time of contribution.
Roth IRAs have income restrictions, so some people who don’t qualify for a Roth IRA choose to do a Roth conversion, converting either all or part of eligible accounts into a Roth IRA so they can take advantage of the tax-free withdrawals in retirement. This can be a tricky process. If converting a Traditional IRA to a Roth IRA, you will owe ordinary income taxes on any previously deducted Traditional IRA contributions and on all earnings. We suggest that you discuss tax issues with a qualified tax advisor.
What You Need to Know About 401(k) and IRA plans, And About Having Both
Here are some other elements to keep in mind:
In 2021, the annual limit for 401(k) contributions is $19,500, plus $6,500 for those over the age of 50 for catch-up contributions.
For IRAs, you can only contribute a maximum of $6,000 in a year, plus a $1,000 catch-up limit for those 50 and older. (One important note: The $6,000 contribution limit applies to all of your IRA accounts, in case you have more than one. In other words, if you have a Traditional and a Roth IRA you can contribute $6,000 between both accounts, not $6,000 to each.)
This is where the magic happens when you have both types of accounts. When you combine the contribution limits of a 401(k) and an IRA, you’re able to put as much as $33,000 into your retirement accounts, if you are 50 or older, or $25,000 if you are under age 50.
Types of IRAs
There are several types of IRAs, but the most common are Traditional and Roth. When you’re weighing the options of one or the other, the most important consideration is which tax bracket you anticipate falling into when you retire, which may be lower than when you were working. If that’s the case, a Traditional IRA might be more suitable for you.
- Traditional: If you don’t have access to an employer-sponsored 401(k) (or similar) plan, a Traditional IRA is fully tax-deductible. If you do have an employer-sponsored 401(k), your Traditional IRA deductions are phased, based on your Modified Adjusted Gross Income (MAGI) levels. You pay tax on 401(k) monies when you make withdrawals, based on the income bracket you’re in at the time of the withdrawal.
Don’t forget: With a Traditional IRA, you’ll have to begin taking Required Minimum Distributions (RMDs) by April 1 the year after you turn 72, and every year thereafter. Otherwise, the IRS will impose a penalty of 50 percent of the amount you should have withdrawn.
- Roth: Although you don’t get the upfront tax break that a Traditional IRA offers in the way of tax deduction, a Roth IRA does grow tax-free, with the added benefit of tax-free withdrawals beginning at age 59-½, provided you’ve held the account for at least five years.
Another perk: There are no RMDs with Roth IRAs.
Benefits from a 401(k) and an IRA
If you want to make a plan for your retirement savings and prioritize tax breaks, the first step is to contribute at least as much to your 401(k) as you need to in order to receive your employer’s full matching amount. Talk to your financial advisor about contributing more, if possible, including catch-up contributions, if you qualify.
Next, consider contributing the annual maximum to the IRA of your choice, again, taking advantage of any catch-up amounts, if you qualify.
Of course, everyone’s financial situation is unique. There are a number of factors to take into consideration, including current and expected future income, risk tolerance, current and expected future expenses, your plans in retirement, your age, your family structure – the list goes on. Talk to your financial advisor to customize a plan that works for you.
For more than 30 years, Scarborough Capital Management has been helping busy people both locally and nationwide make the most of their money. With affordable 401(k) management services plus full-service financial planning and wealth management, we’re passionate about helping you achieve your financial goals, both now and in the future.
If you have questions about your retirement or wonder if you’re saving enough, schedule a conversation with our team of financial advisors. We are happy to help you analyze your 401(k) and discuss your options.