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Pairing 401(k) and IRA Contributions

Peter A. ScilovatiOctober 2, 2020

Retirement Planning

Clients continue to ask the question:  “I am thinking of contributing to an IRA account in addition to making my 401k retirement plan contributions. When can I start?” As much as we at HFA love to hear about aggressive retirement savings plans from our clients, we are always careful to point out that when it comes to pairing IRA contributions with qualified retirement plan contributions (401k, 403B, 457, SARSEP) “the devil is in the details”!

According to the Investment Company Institute, approximately 33% of American households use IRAs as a retirement savings vehicle. The tax-deductible amount you can contribute each year to an IRA depends on factors like your age, income, and most importantly whether you’re covered by one of those qualified plans.

Let’s take a step back.  A 401(k) or other employer-sponsored retirement plans are considered by many to be their primary retirement savings vehicle. Contributions are easy because they automatically come out of your paycheck and are not included in your federal taxable wages. The annual contribution limits are sizable: $19,500 for tax-year 2020, plus a $6,500 catch-up for those age 50 or older. That means, depending on your age, you could contribute up to $26,000 in 2020. Not to mention, most employers provide a match to a portion of their employee’s contributions.  We advise clients to contribute at least as much (on a percentage basis) to meet the requirement for company matching contributions, otherwise free money is left on the table.

For many clients with unspent discretionary income a case can be made for contributing to an IRA (Traditional or Roth) in addition to their 401(k) plan. An IRA not only gives you the ability to save even more, it might also give you more investment choices than you have in your employer-sponsored plan.  Prior to January 1, 2020, individuals needed to be under age 70½ to contribute to a Traditional IRA. The SECURE Act repealed the age restriction for Traditional IRA contributions. Effective for 2020 and later taxable years, individuals with earned income can make Traditional IRA contributions for themselves and their spouse at any age.

Sounds simple but here’s where we find the devil in the details. For 2020, the annual contribution limit for both a Traditional and Roth IRA is $6,000 with a $1,000 catch-up if you’re age 50-plus. However, each type of IRA does have an income ceiling that will determine whether one or the other is right for you. If you are not covered by an employer retirement plan, your contributions to a Traditional IRA are fully tax deductible. For those who are covered by an employer plan, the income limits for determining the deductibility of Traditional IRA contributions in 2020 must be considered. If your filing status is single or head of household, you can fully deduct your IRA contribution up to $6,000 ($7,000 if you are age 50 or older) in 2020 if your modified adjusted gross income (MAGI) is $65,000 or less. Partial deduction is permitted for MAGI between $65,000 and $75,000. If your modified AGI is $75,000 or more, you can’t take a deduction for contributions to a Traditional IRA. If you’re married and filing a joint return, you can fully deduct up to $6,000 ($7,000 if you are age 50 or older) in 2020 if your MAGI is $104,000 or less. Partial deduction is permitted for MAGI between $104,000 and $124,000.  If your modified AGI is $124,000 or more, you can’t take a deduction for contributions to a Traditional IRA.  If you are married and your spouse is covered by a retirement plan at work and you aren’t, and you live with your spouse or file a joint return, your deduction is phased out if your modified AGI is more than $196,00 but less than $206,000 . If your modified AGI is $206,000 or more, you can’t take a deduction for contributions to a Traditional IRA. The key here is the fact that an individual can always contribute to a Traditional IRA. The only outstanding question is the tax deductibility of the contribution.

Things are a bit different with a Roth IRA for which contributions are not tax deductible  There are income phase-out limits based on your MAGI that determine whether you’re even eligible to contribute and how much you can contribute to a Roth IRA. In 2020, the limits are $124,000-$139,000 for single filers and $196,000-$206,000 for married filing jointly. Couples with incomes between $196,000 and $206,000 can make partial Roth contributions. Once their income exceeds $206,000, they no longer qualify to make the contribution. So, the only outstanding question for the Roth IRA is the eligibility or allowability of the contribution based on the income limits.

More and more employer plans are offering the option of contributing to a Roth “bucket or sleeve” within the 401k plan with after-tax dollars. There is no  income phase-out limit in the Roth sleeve or bucket of the 401(k). You can make  both a before-tax contribution and a Roth after-tax contribution to your 401(k) account at the same time.  Splitting your contributions between the two types (up to the annual contribution limits of $19,500 or $26,000) gives you a combination of both taxable and tax-free withdrawals come retirement time.

The Roth 401k bucket is akin to a combination of a traditional 401(k) and a Roth IRA. As with a Roth IRA, you pay the taxes up front. Withdrawals in retirement are tax-free. The Roth 401k has many similarities to the traditional 401k, such as the contribution limit and the potential ability to receive matching contributions from your employer.

Think of traditional and Roth accounts like farming. With a traditional 401k or IRA, you pay taxes on the harvest. With a Roth IRA or 401k, you pay taxes on the seeds. It’s not necessarily the case that one option is better than the other. An important thing to consider when choosing between IRAs is whether you believe you’ll be in a higher or lower tax bracket when you retire.  Withdrawals from a Traditional IRA are taxed at ordinary income tax rates and qualified Roth withdrawals are tax-free. Also, there’s no required minimum distribution (RMD) for a Roth, but with a Traditional IRA, you’ll have to begin taking an RMD after age  72, provided  you were born on or after July 1, 1949.

We encourage clients, in addition to their family and friends, to reach out to us with qualified plan, IRA, and specific investment or financial planning related questions. Please call our office to discuss further 610-651-2777.

 

Sources:

Investopedia: Making Spousal IRA Contribution
IRS.gov Publication 590-A
Robinhood.com
Ascensus.com
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