Should You Have an IRA and a 401(k)?

A 401k is a retirement account. It is often referred to as an employer sponsored retirement plan as you can only contribute to the account if your employer offers one. When you contribute to a 401k, a portion of your paycheck is automatically taken out and invested into the investments that your 401k plan offers.

Additionally, your employer may offer to match your contributions. For example, say that you make $80,000 per year and your employer offers a 3% match. If you contribute 3% of your salary to your 401k, which would be $2,400, your employer would match that contribution and add another $2,400 to your 401k.

IRAs, or individual retirement accounts, are retirement accounts that you can open outside of work through an online broker or robo advisor. These accounts can be opened by anyone who meets the requirements as they are held outside of work.

Both the 401k and IRA have two main types - the Roth 401k/IRA and the Traditional 401k/IRA. The Roth and Traditional differ in the way that they are taxed. Depending on your situation, one may be better for you than the other.

Both the 401k and IRA offer tax benefits. The two types of 401(k)s and IRAs are Traditional and Roth. A Traditional 401k or IRA offers what is called a tax deferred benefit. A Roth 401k or IRA offers what is called a tax free benefit.

Traditional accounts

Traditional accounts offer what is called a tax deferred benefit. When you contribute to a Traditional retirement account, you do not pay taxes until you withdraw the money in retirement. You are essentially telling the IRS that you want to wait to pay taxes until you retire.

For example, say that your employer offers a Traditional 401k plan. When you contribute to this account, all of the money that your investments within the account grow tax deferred. When you retire, you take the money out which will then be subject to taxes.

Traditional 401(k)s also allow you to deduct the contributions that you make. For example, say that your income was $100,000 per year and you contributed $10,000 to your 401k. You can deduct this contribution, which would reduce your taxable income to $90,000 for the year ($100,000 salary - $10,000 401k contribution).

Similar to a Traditional 401k, a Traditional IRA also offers a tax deferred benefit. This means you won't owe any taxes on the growth of the account until you take the money out in retirement. Traditional IRA contributions may be tax deductible, but it depends on your income and whether or not you already have a Traditional 401k.

Roth accounts

Roth accounts work in the opposite way of Traditional accounts by offering a tax free growth benefit. You do not get to deduct the contributions that you make to Roth accounts. However, when you put money into a Roth account, that money grows tax free and can then be withdrawn tax free.

When you contribute to a Roth account, you are saying that you want to pay taxes on the dollars you contribute today so that you won't have to pay taxes on the money in the account in retirement. Both the Roth IRA and the Roth 401k offer this tax free benefit.

It is important to note that while the contributions you make to a Roth 401k offer a tax free benefit, your employer match may not. If your employer matches your Roth 401k contributions, the match usually goes into a Traditional 401k. Your employer matches would be subject to taxes in retirement.  

In order to use a 401k and/or an IRA there are eligibility requirements that you must meet.

401k

Your employer may have specific eligibility requirements that you must meet before you can participate in your plan. This may include being a certain age and working a certain amount of time with the company before you can contribute. Check with your employer to see what guidelines they have.

Roth IRA

Unfortunately not everyone can have a Roth IRA. The first requirement you must meet is that you must have earned income - such as income from a job to open a Roth IRA. Secondly, your income can't exceed certain levels if you want to open and contribute to a Roth IRA.

If your tax filing status is single or head of household, your modified adjusted gross income (MAGI) has to be $146,000 per year or less to make the maximum contribution to a Roth IRA. If your income is between $146,000 and $161,000 you can contribute a reduced amount to a Roth IRA.

However if your income is $161,000 or above, you can't use a Roth IRA at all. If your tax filing status is married filing jointly or qualified widow(er), your modified adjusted gross income (MAGI) has to be $230,000 per year or less to make the maximum contribution to a Roth IRA.

If your income is between $230,000 and $240,000 you can contribute a reduced amount to a Roth IRA. However if your income is $240,000 or above, you cannot use a Roth IRA at all.If your income is too high that you are not able to use a standard Roth IRA, you can get around the problem by using a Backdoor Roth IRA instead.  

Traditional IRA

The good news is that anyone who has earned income can open and use a Traditional IRA. The IRS defines earned income as taxable compensation. This would include wages or salaries from an employer. As long as you have this, you can open and use a Traditional IRA.

If you are at least 18 years old, you can open and hold a Traditional IRA in your name. If you are younger than 18 years old, you will need the help of a parent or guardian to open an IRA. For example, a 16 year old that works at a local business can open an IRA and contribute to it with the help of a parent.

Traditional 401k
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For 2024, the max amount you can contribute to a 401k is $23,000 per year or $30,500 per year if you are 50 or older. These are just the contributions that you are allowed to make. With an employer match, the amount you could invest each year could be higher. However, the max amount that you and your employer can contribute to the account is $69,000 per year.

Roth or Traditional IRA

The maximum amount you can contribute to a Roth or Traditional IRA is $7,000 per year or $8,000 per year if you are 50 and older. For the Roth IRA, you may also be able to contribute a reduced amount if your income is above the level that allows you to make the maximum contribution.

Withdrawal rules simply dictate when you are allowed to start pulling money out of the account.

Traditional 401k
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You are not allowed to pull any of the money out of a Traditional 401k until you are at least 59 and a half years old. If you try to access the money in the account before then, you can incur a 10% penalty on the amount you withdrew, as well as any applicable income taxes. There are certain exceptions to this rule. You will owe taxes on these withdrawals since it is a Traditional account.

Roth 401k

You are not allowed to pull any of the money out of a Roth 401k until you are at least 59 and a half years old, and have contributed to the account at least 5 years earlier. If you try to access the money in the account before then, you can incur a 10% penalty on the amount you withdrew, as well as any applicable income taxes. If you follow these rules, you will not owe any taxes since it is a Roth account.

Traditional IRA

Once you are 59 and a half years old, you can start withdrawing money from a Traditional IRA. If you try to withdraw the money before then, you will incur a 10% penalty as well as any applicable income taxes. You will owe taxes on these withdrawals since it is a Traditional account.  

Roth IRA

Once you are 59 and a half years old, and have contributed to the account at least 5 years earlier, you can start withdrawing money from a Roth IRA. If you try to withdraw the money before then, you will incur a 10% penalty as well as any applicable income taxes. If you follow these rules, you will not owe any taxes since it is a Roth account.

401k plans typically offer a small selection of investment funds that you can hold in the account. These funds are collections of stocks and bonds so that you do not have to pick individual investments. Common types of funds might include index funds, ETFs, and target date retirement funds.

The funds may be comprised of large cap, small cap, and medium cap US companies, as well as international companies. You are only allowed to choose from the investments that your specific 401k plan offers. IRAs on the other hand offer a much broader investment selection.

Since IRAs are held outside of work, you can buy almost any stock and bond that you want if it is offered through a broker. You can buy investment funds, as well as individual stocks and bonds, that are not offered by your 401k plan through an IRA if it makes sense for you to do so.

We have already emphasized that you should use both a 401k and an IRA if you are in the position to do so. However, when you use a combination of these accounts, you need to decide whether to send your dollars to Roth accounts, Traditional accounts or both.

Traditional accounts are tax deferred, meaning you won't pay taxes on the growth of the investments within the account until retirement. Roth accounts grow tax free, which means that when you pull the money out of the account in retirement, you won't owe any taxes.

There is a general rule of thumb that you can follow to make a decision. If your taxes are going to be lower in retirement, you want to use Traditional accounts. For example, say that you currently pay 30% in taxes today, but anticipate your taxes to be 25% in retirement.

If these assumptions ended up being true, you would want to use a Traditional 401k and IRA to save for retirement. Traditional accounts allow you to defer or wait to pay taxes. You would wait to pay your taxes until your tax rate dropped in retirement.

On the flip side, if you anticipate that taxes will be higher in the future, you should use Roth accounts. For example, say that you currently pay 30% in taxes, but anticipate that taxes will rise in the future at which point you would owe 35% in taxes.

With Roth accounts, you pay taxes on the dollars you contribute today, but then get to enjoy tax free withdrawals in retirement. If taxes are going to be higher in the future, it makes more sense to pay taxes now when they are lower, and enjoy tax free withdrawals when taxes are higher.

Keep in mind that the rules listed above are only meant to serve as a general guideline. You have to look at your individual financial circumstances to determine whether to use Roth accounts, Traditional accounts, or a mix of both. A competent financial advisor can help you navigate this difficult decision.

If your employer offers to match your contributions, you want to invest enough into your 401k (whether a Roth or Traditional 401k) to get the full match. This is especially true if your employer offers a dollar for dollar match. The reason for this is that you are getting a 100% rate of return.

When you put a dollar in and your employer matches that dollar, it is a better return than what your investments within the account will get. So, if you make $100,000 per year and your employer offers a 5% match, you want to invest at least $5,000 (5% of your salary) into your 401k per year to get the maximum match.

Many individuals will say that an employer match is "free money." While we understand the sentiment, your 401k plan may have a vesting schedule. A vesting schedule simply determines when your employer matches become yours.

For example, your employer may have a 1 year vesting schedule on their 401k plan. This means that their matching contributions won't be yours for at least a year. If you leave the company before a year, you won't own your employer's contributions. The contributions that you make are always yours to keep.

After you get your employer's match, you want to fund an IRA (Roth or Traditional depending on what is best for you) up to the limit. Although a 401k does have benefits, it does not offer a wide selection of investments and your employer gets to dictate the rules of the plan.

When you own an IRA, you have more control over your investment selection and the plan itself. Since an IRA is held outside of work, you are not dependent on your employer to offer a retirement plan. An IRA will follow you everywhere you go.

If you still have money to invest after completing steps one and two, you have a couple of different choices. Some individuals recommend jumping back to your 401k and contributing any remaining dollars you have to the account. There is nothing inherently wrong with this, but there may be better options for you.

You can evaluate your financial goals and look to see if there are other investments that you want to make. For some individuals this may include buying a rental property or opening a brokerage account. Some individuals may also consider insurance products such as annuities and whole life insurance.

If you do decide that you want to have an IRA in addition to a 401(k), there are a few places you can open the account. First, you can use an online broker. An online broker will allow you to buy a large selection of assets that you can hold within an IRA.

If choosing your own investments through an online broker sounds intimidating, you can also use a robo advisor. A robo advisor is a digital financial advisor that will pick investments for you based upon your answers to an online questionnaire.

The process of opening an IRA is straightforward. Simply go to the website of your desired broker or robo advisor and click to open an account. From there, you will fill out the necessary paperwork. Once your account is approved simply deposit funds from a bank account and use those funds to buy your investments.

The bottom line is that you should have both a 401k and IRA. Contribute enough to your 401k to get your employer's match and then fund an IRA up to the limit. Once you have done this, open up an IRA and fund it to the maximum limit.

Finally, you can look to other investment opportunities if you still have money left over to invest after completing the first two steps. Whether you use Traditional or Roth accounts will depend on your assumptions of your future tax rate compared to your current tax rate.