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What you Need to Know About Contributing to a 401k and an IRA

By December 7, 2021February 11th, 2022News

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To help achieve your financial goals, you need to think about how to best invest your current income. Establishing retirement accounts such as a 401(k) and an individual retirement account (IRA) will give you two reliable ways to build your retirement savings and plan for your ideal future.

But how can you best contribute to both simultaneously?  Learn the pitfalls, contribution limitations, and best strategies for diversifying your retirement savings into both a 401K and an IRA.

Jump into sections: 

Key Features of an IRA and a 401k

With both a 401(k) and an IRA, you can invest income to create tax-deferred savings for the future. Each retirement plan comes with its own features, limitations and benefits. The choice of where to focus your income depends on your unique financial situation.

IRA

Traditional and Roth Individual Retirement Accounts (IRAs) are tax-favored investment accounts that allow individuals to invest in stocks, bonds, mutual funds, ETFs and other investments. Traditional IRA accounts come with tax benefits, such as a tax deduction on contributions. These are ideal if your employer does not offer a retirement plan, but also complement your 401(k). Roth IRAs are the more flexible version, built with after-tax dollars that will not be taxed in the future.

401k

A 401(k) is an employer-sponsored retirement plan that comes with different investment options, ranging in risk. When an employee contributes to their 401(k), the employer may match the amount up to a certain percentage. A 401(k) has large contribution limits, making it easier to reach one’s financial retirement goals. They also come with tax benefits, as you can subtract 401(k) contributions from your reported annual income.

IRA Eligibility and Contribution Limits

Contributing to an IRA requires earned income. If you earn limited income (below the maximum annual contribution limit), then you can only contribute the total amount of income you earned during a particular year. The exception for this rule concerns married couples where only one spouse works outside of the home. For 2021, the contribution limit for IRAs was $6,000 for people under 50 years old and $7,000 for those over 50 years of age.

For a Traditional IRA

Traditional IRAs invest pre-taxed dollars to build retirement savings. Up to a certain income, you can receive a tax deduction on your contributions, though the contribution limit is the same for both traditional and Roth IRAs. Anyone who has earned income can participate in a traditional IRA.

Roth IRA Contributions

People make Roth IRA contributions with dollars that have already been taxed. While Roth IRA contributions do not come with a tax deduction, they have more flexibility than traditional IRAs. You can withdraw the contributions from your Roth account tax- and penalty-free anytime and withdraw earnings tax-free once you reach 59-1/2 years old. A Roth IRA, unlike traditional IRA, does come with a downside. If you are single and earn more than $140,000 annually, you cannot make any contributions to Roth IRAs.

Spousal IRAs

Spousal IRAs allow employed spouses to contribute to the IRA of their nonworking spouse, increasing the family’s retirement savings. Spouses can establish either a traditional or Roth IRA for this purpose.

IRA Benefits and Drawbacks

IRAs are available to anyone with an earned income. IRAs offer numerous investment options, including stocks, bonds, mutual funds and ETFs. While the contribution limit is lower for an IRA than a 401(k), you also have lower management fees and more freedom to make investment decisions. The contributions you make to your traditional IRA come with a tax deduction, a key benefit and reason people seek out IRAs.

However, the amount that is tax-deductible depends on your income and your 401(k). If you exceed the income requirements, you may only receive a partial tax deduction or none at all. This does not stop you from making nondeductible contributions to your account. Based on your income, it may be more beneficial to you to contribute any after-tax dollars to a Roth IRA versus a traditional IRA.

401(k) Benefits and Drawbacks

Having a 401(k) provides several benefits, including employers matching a percentage of your contribution at times. You also usually have the choice between different investment options of varying risk levels, allowing you to pick one that suits your risk tolerance. The funds within the account grow without taxes on the interest and earnings. Additionally, you reduce your taxable income by the contribution amount. Unfortunately, 401(k) retirement funds often come with limited investment options and high management fees.

Which Account Is Better?

Neither type of account is better than the other. Instead, a 401(k) and an IRA present you with two different investment options with their own benefits and drawbacks. Your financial goals, your income and the quality of investments offered by either account will influence which account you prioritize and how much you contribute to each.

Can I Have Both a 401k and an IRA?

You can have both a 401(k) and an IRA. Many people use both types of accounts to increase their earnings, diversify their investments and maximize tax advantages.

The complication of investing in both 401(k)s and IRAs comes down to whether your IRA contribution is considered tax deductible. This depends on your filing status and your spouse’s income. For example, if you are married with your own 401(k), then your full contribution to your IRA is tax deductible only if you make less than $105,000.

These potential complications should not be a reason for you to choose one over the other. They can work together to provide more savings with some extra flexibility.

The Benefits of Having a 401k and an IRA

Your 401k can serve as the backbone of your retirement plan. After all, it’s easy to save because your contributions are automatically taken out of your paycheck and your employer hopefully matches some or all of your contributions. However, having just a 401k might not be enough to help you reach your retirement goals. 

 

That’s where having an IRA to contribute to in addition to your 401k comes in with an assist. An IRA gives you another way to save, plus it provides you with more investment choices. The two combined make your retirement plan that much stronger.

Annual Contribution Limits for 2021

In 2021, you could contribute a maximum of $19,500 to your 401(k). If your age exceeds 50 years old, you have the option to contribute another $6,500 to your account, amounting to $26,000.

The IRS limited contributions to IRAs to $6,000 in 2021, or $7,000 for people 50 years old or older. If you have both a traditional and Roth IRA account, then the limit applies to your accounts combined.

What if You Contribute Too Much?

If you contribute more than the maximum limit to your 401(k) or IRA, you need to quickly correct the error by withdrawing the excess amount. This way you avoid a 6% excise tax every year on the amount that exceeds the limit.

This penalty does not occur if you withdraw the money before you file your taxes for the year you made the contribution. The process becomes more complicated, though, because you have to calculate how much the excess contribution earned and withdraw that amount, too. The investment gain will be taxed, and you will experience a 10% early withdrawal penalty for the amount.

What Should You Do After Maxing Out Your 401k and Roth IRA?

After maxing out your 401k and your Roth IRA, you can find other ways to invest. Pensions, real estate, municipal bonds and investing in business represent different avenues for investments. You should look into the amount of risk that comes with different investment options and choose one that works for your comfort level.

Conclusion

Having both a 401k and an IRA is a good idea since they are excellent ways to increase your earnings and diversify your investments. Just be careful to avoid penalties by staying within the contribution limits for your age. If you max out both and still want to keep investing for retirement, you’ll need to pursue other avenues for investing.

FAQs

What is the difference between an IRA and a 401k?

The main difference between a 401(k) and IRA is who manages it. You can establish an IRA through a bank or investment firm, and you manage your own account. On the other hand, employers provide employees with 401(k)’s, and while you make some investment decisions, you are not the person who personally manages the account.

Can I contribute the maximum to my 401k and an IRA?

You can contribute the maximum to your 401(k) and IRA, but first, you should consider your current financial needs and goals.

Contributing the maximum amount to your retirement plans may negatively impact your current budget. You need to pay taxes, your bills, any outstanding debts or loans and budget for daily expenses. You should also consider specific financial goals, such as buying a home or raising a child, that you want to save for.

How much can I contribute to an IRA if I also have a 401k?

If you already have a 401(k), you can still maximize your IRA contribution. In 2021, you could contribute a maximum of $6,000 to your IRA, or $7,000 if you were 50 years old or older. The decision to max out your IRA depends on your current financial situation, goals and future plans.

How much can you contribute to a 401k and a Roth IRA in the same year?

You make a maximum 401(k) contribution of $19,500 and a maximum Roth IRA contribution of $6,000 in the same year, if you are under the age of 50. For those 50 years old and older, you can make a catch-up contribution of $26,000 to your 401(k) and $7,000 to your Roth IRA. Exceeding these maximum amounts has penalties, and whether you want to max out your accounts depends on your current financial situation.

Preparing For Your Ideal Future

Want to learn more information about your retirement options? With Churchill Management Group, you can speak to experienced financial advisors who prioritize your best interests and financial goals. If you have questions, contact Churchill Management Group at 877-937-7110 or through our website today.

Financial Planning Services Disclosure; Churchill provides financial planning services to Clients that specifically engage Churchill for that service. The planning can include defining goals, designing a plan, assisting with implementing the plan, and evaluating and adjusting the plan over time, at the request of the client. The financial planning includes advice regarding securities investing and may include discussions of a client’s tax, insurance, employee benefits, estate planning, and other issues. Churchill, however, does not provide legal, insurance, employee benefit, estate planning, tax, or accounting advice, and the client must rely on legal, insurance, and accounting professionals for that advice and documentation.

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