What we’re discussing in this article:
- Eligibility of who can contribute to a Roth IRA and a 401K – there are income limits for a Roth IRA, see if you qualify below
- Other combinations of IRA types like SEP IRAS or Traditional IRAs if it makes sense for you tax-wise
- An explanation of pretax and after-tax dollars, and why it matters
Investing in a 401K plus an IRA (A Roth IRA for example in this article) offers the perfect combination of tax savings—some now and some in the future. Because Roth IRA contributions are made with after-tax dollars, there’s no conflict between this type of plan and a 401K. There are some contribution and deduction limits, but you’re permitted to contribute to both if you qualify.
Breaking Down Pretax and After-Tax Dollars
A Roth IRA is a great choice if you’re already making regular contributions to a 401K and you’re looking for a way to save even more retirement dollars. 401K contributions are made with pretax dollars, whereas Roth IRA assets involve saving your after-tax dollars.
Eventually, the money that represents your contributions to a 401K will be taxed upon distribution because you haven’t yet paid taxes on that money. Roth distributions of principal monies will not be taxed because you’ve already paid taxes on your contributions. The investment growth in both these accounts is tax-deferred until retirement.
Who is Eligible?
If your 401K is hosted through your employer, speaking with your human resources administrator can help you determine your eligibility. The Internal Revenue Code limits 401K contributions to no more than $19,000 a year in 2019, or $20,000 if you’re 50 or older.
Your modified adjusted gross income (MAGI) must be $137,000 or less as of 2019 to be eligible to contribute to a Roth IRA. This limit applies if your filing status is single or head of household. It increases to $203,000 if you’re married filing jointly or a qualifying widow(er). The cap for those who are married and filing separate returns is $10,000.
Other Retirement Account Combinations
If you don’t have a 401K through work, you can contribute to both a traditional IRA and a Roth IRA as long as your combined contributions don’t exceed the 2019 annual limit of $6,000. Again, this increases to $7,000 for those who are age 50 or older.
Note that it might not make sense to contribute to a traditional IRA and 401K in the same year unless you’re eligible for deductible contributions; the reason is because these two accounts are designed to do exactly the same thing. The only difference is that IRAs have much lower contribution limits than 401Ks.
Also note that you can contribute to a small business retirement plan, such as a SEP IRA, if you earn income from freelance or contracting work on the side.
How Much to Contribute
It’s usually advisable from a financial planning perspective to take full advantage of any employer matching contributions to a retirement plan at work before considering an IRA. It makes sense to contribute at least as much as the matching percentage if your employer matches 401K contributions.
Ten to 15 percent of pretax income is a good rule of thumb for serious retirement investors. After that, consider maxing out a Roth IRA, or at least set aside as much as you can into this type of account throughout the year. The tax benefits will pay off, particularly if you expect your income tax rate to rise over time.