It’s nice to have options when it comes to saving for retirement. IRAs and workplace retirement plans, like 401(k) plans, not only help you save for your future, but they can also allow you to reduce your current taxable income, choose when to pay tax on your savings, defer taxation on investment growth, and grow your investments tax-free. Because of the numerous tax breaks these accounts provide, the laws limit who is eligible to contribute and how much can be contributed each year.
While you can have both an IRA and a 401(k) plan, saving in multiple accounts may affect the tax benefits available to you. Knowing the benefits and considerations for each type of account can help you make the right moves to improve your finances – now and in the future.
IRA vs. 401(k) Contribution Limits
The amount you can save in a 401(k) far exceeds what you can put in an IRA each year:
- 401(k) plan – You may defer up to $22,500 from your paychecks into your employer’s 401(k) plan for 2023. If you’re age 50 or older, you can contribute an additional $7,500.
- IRA – You may deposit up to $6,500 into your Traditional and Roth IRAs in total for 2023. If you’re age 50 or older, you can deposit an additional $1,000.
Between the two types of accounts, an individual age 50 or older could save up to $37,500 pre-tax in 2023. While most people can’t afford to do that, there are ways to contribute strategically to multiple accounts to maximize the benefits available to you.
Traditional IRAs
An IRA is an individual arrangement that you control including where you open an account, how and when you fund it, how you invest it, and when you withdraw from it. To be eligible to contribute to a Traditional IRA, all you need is earned income at least equal to the amount you contribute.
Most investors contributing to a Traditional IRA expect to take a tax deduction for their contribution. A tax deduction lowers your taxable income for the year, which can reduce your tax liability. But, with tax-deductible contributions and tax-deferred investment growth, Traditional IRA assets are taxable to you when you withdraw them. This can increase your taxable income – and tax liability – in retirement.
Not everyone is eligible to take a deduction for their Traditional IRA contribution. If you do not participate in a workplace retirement plan, you may take a tax deduction for your contribution. But if you or your spouse participate in a workplace retirement plan, your income must fall below a certain threshold to qualify for a tax deduction. For example, for 2023, if you are married and your Modified Adjusted Gross Income (MAGI) exceeds $116,000, your contribution will only be partially deductible until you reach $136,000 when you are no longer eligible for a deduction. If you don’t participate in a workplace plan but your spouse does, the income phase-out range is $218,000–$228,000. The MAGI ranges are different if you’re tax-filing status is single. See IRA Contribution Limits for more information.
If you aren’t eligible for a tax deduction, you can still make a nondeductible contribution to a Traditional IRA.
Roth IRAs
Roth IRA contributions are always non-deductible. The benefit of a Roth IRA comes when you take money out of the IRA. Because you are already paid tax on the money going in, you will not be taxed again when it comes out. Investment earnings grow tax-deferred and will be tax-free when withdrawn if you’ve had a Roth IRA for at least 5 years and you are 59½ or older, disabled, buying a first home, or deceased.
Because of the great potential for tax-free investment earnings, individuals with higher incomes are not eligible to contribute to Roth IRAs. Eligibility to contribute phases out for single filers between $138,000–$153,000 for 2023, and $218,000–$228,000 for married, joint filers.
Participating in a 401(k) plan (or other workplace plan) does not have any bearing on your eligibility to contribute to a Roth IRA. In fact, many people contribute to a Roth IRA and a 401(k) plan to take advantage of the different tax benefits.
401(k) Plans
A 401(k) plan allows you to defer a significant amount of your paycheck into the plan before taxes are calculated and withheld on your pay. Many 401(k) plans also offer designated Roth accounts for after-tax contributions, which offer similar tax benefits as a Roth IRA. Employers sponsoring a 401(k) plan may choose to contribute to employees’ accounts, either by matching a percentage of employee salary deferrals or making a profit sharing or other type of contribution. In total, a 401(k) plan participant can have up to $66,000 contributed to their account for 2023, plus the $7,500 catch-up contribution if age 50 or older.
Workplace plans are controlled by the employer and are subject to more restrictions under the tax laws. You must first meet the 401(k) eligibility requirements to participate in the plan. If you’re a highly compensated employee, the plan may limit your contributions to pass certain nondiscrimination tests. The employer selects the investments available to you, and the law restricts when you can take money out of the plan – usually not until you leave the employer or have a specific financial hardship.
If you are self-employed and do not have any employees, you can adopt an Individual 401(k) plan and contribute as much or as little as you want to your account as salary deferrals and profit sharing contributions, and contribute to a Traditional IRA and, if eligible, a Roth IRA – as long as you stay within the contribution limits.
If you contribute too much to any of these accounts, you will need to remove the excess contribution for the year to avoid a tax penalty.
Talk to your tax or financial advisor for help determining the exact combination of accounts and contribution amounts to best fit your retirement income goals.