Saving in Both a 401(k) and a Roth IRA

Why It Makes Sense to Save in Both a 401(k) and a Roth IRA

A simple retirement saving formula.
A simple retirement saving formula. David Franklin/Getty Images

If you're the type of person who can't pass up a good tax break, investing in a 401(k) and a Roth IRA offers the perfect combination of tax savings: some now and some in the future.

401(k) Plus Roth IRA 

If you are making regular contributions to a 401(k) and are looking for another way to save even more retirement dollars, a Roth IRA is a great choice. Investors who qualify can contribute to both a 401(k) and a Roth IRA in the same year, and there are good reasons to do so.

While 401(k) contributions are made with pretax dollars, Roth IRA assets come from your after-tax check. Investments in both grow tax-deferred until retirement, but the money you take out of a 401(k) will be taxed while Roth distributions will not. 

Roth IRA contributions (but not earnings) can also be withdrawn tax-free before retirement, as long as the money has been held in the account at least five years. That makes a Roth IRA a great savings vehicle for other goals, like a buying a house or paying for grad school or a child's college savings. And while 401(k) and traditional IRA investors are required to begin taking distributions from those accounts at age 70 1/2, there are no distributions required from a Roth until after the owner's death. 

Who Is Eligible? 

If you work for a company that offers a 401(k), your human resources administrator can help you determine your eligibility. The IRS limit for 401(k) contributions is $18,000 per year during 2016 ($24,000 if you are 50 or older).

401(k) Contribution Limits for 2016

To be Roth IRA eligible, your modified adjusted gross income in 2016 must be $132,000 or less your income tax filing status is single, head of household, or married filing separately and you did not live with your spouse at any time during the year. If you are married filing jointly your modified adjusted gross income must be $194,000 or less.

 

Other Retirement Account Combinations

If you don't have a 401(k) through work, you can contribute to a traditional IRA and a Roth IRA combo as long as your combined contributions do not exceed the $5,500 combined annual limit ($6,500 for ages 50 or older). 

It makes less sense to contribute to a traditional IRA and 401(k) in the same year unless you are eligible for deductible contributions. The two accounts are designed to do exactly the same thing. The only difference is that IRAs have much lower contribution limits than 401(k)s. In 2016, you can put up to $18,000 into a 401(k) (or up to 24,000 if you are age 50 or older) and $5,500 in an IRA (or up to $6,500 with the catch-up contribution). Investors who have a 401(k) do not automatically qualify for an upfront IRA deduction. 

If you are participating in a 401(k) plan at work and are single or file a tax return as head of household you can qualify for a full deduction if your modified AGI is less than $61,000. The deduction amount phases with adjusted gross incomes (AGI) of between $61,000 and $71,000. Individuals with income above $71,000 will not likely qualify for a deductible IRA contribution. For married couples filing joint tax returns and the spouse making the IRA contribution is covered by a 401(k) or related plan at work, deductions begin to phase out at $98,000 and are capped at $118,000.

From a financial planning perspective it is advisable to take full advantage of any employer matching contributions to a retirement plan at work before considering an IRA.

If you earn income from freelance or contracting work on the side, you can contribute to a small-business retirement plan, such as a SEP IRA. SEP contributions are fully deductible up to 25 percent of gross annual income or $53,000 in 2016, even if you max out your 401(k) contributions, which can really put a dent in your tax bill. 

How Much to Contribute to a 401k and Roth IRA

If your employer matches 401(k) contributions, it makes sense to contribute at least as much as the matching percentage. A full 10 to 15 percent of pre-tax income is a good rule of thumb for serious retirement investors. After that, max out a Roth IRA or stuff as much as you can into one throughout the year.

The tax benefits will pay off, particularly if you expect your income taxes to rise over time. 

The content on this site is provided for information and discussion purposes only. It is not intended to be professional financial advice and should not be the sole basis for your investment or tax planning decisions. Under no circumstances does this information represent a recommendation to buy or sell securities.

Updated by Scott Spann