• American Financial Partner

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

Updated: Sep 15, 2021

Investing in both a 401(k) plan and a Roth IRA offers the perfect combination of tax savings—some now and some in the future. Roth IRA contributions are made with after-tax dollars, so there's no conflict between this type of plan and a 401(k), which is funded with pre-tax dollars. There are some contribution and deduction limits, but the IRS permits you to contribute to both.

Tax and Distribution Considerations

A Roth IRA is a great choice if you're already making regular contributions to a 401(k) and you're looking for a way to save even more retirement dollars. The money in your 401(k) will be taxed at the time you take it out because you didn't pay taxes on your contributions. Roth distributions of principal will not be taxed because you've already paid taxes on those contributions. The investment growth in both these accounts is tax-deferred until retirement.

Because the value of your Roth IRA contributions can be withdrawn at any time without any taxes or penalties, a Roth IRA a great savings vehicle for other goals, like buying a house or paying for a child's college education.

One more significant difference between a 401(k) and a Roth IRA is that investors in a 401(k) or a traditional (non-Roth) IRA are required to begin taking distributions from those accounts at age 72, while there are no required minimum distributions from a Roth IRA account until after the owner's death (the account's beneficiaries may be required to take RMDs in order to avoid penalties).

Eligibility and Contribution Limits

There are no modified adjusted gross income (MAGI) limits for contributing to a 401(k), so you can make use of this retirement account no matter how much or how little money you make. If you earn above a certain amount of MAGI, you may not be able to contribute to a Roth IRA the full amount legally allowed each year or you may not be able to contribute at all. The amount of your contribution also depends on your income tax filing status. Click here to see IRA contribution and income limits.

The IRA contribution limit for 2021 is $6,000. If you're 50 or older, it's $7,000. To calculate the amount of your permitted reduced contribution, first subtract from your MAGI one of three amounts:

  • $198,000 if you're married and filing a joint return or are a qualifying widow or widower

  • $0 if you're married and filing a separate return and you lived with your spouse at any time during the year

  • $125,000 if you have any other filing status

If you're 49 or younger, you can contribute $19,500 to your 401(k) in 2021. If you're 50 or older, you can contribute an additional $6,500.

Other Retirement Account Combinations

If you don't have a 401(k) through work, you can contribute to both a traditional IRA and a Roth IRA as long as your combined contributions don't exceed the $6,000 or $7,000 annual limit.

It might not make sense to contribute to a traditional IRA and 401(k) in the same year because those two kinds of accounts are designed to do exactly the same thing. The only difference is that IRAs have much lower contribution limits than 401(k)s.

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 contribution to a retirement plan at work before considering putting money in an IRA. It makes sense to contribute at least as much as the matching percentage if your employer matches your 401(k) contributions.

A good rule of thumb for serious retirement investors is 10% to 15% of pretax income. After that, consider maxing out a Roth IRA or at least setting 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.

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