Dear Carrie: I already have a 401(k). Does it make sense to open an individual retirement account, too? — A Reader
Dear Reader: A 401(k) or another employer-sponsored retirement plan — if you’re lucky enough to have one — can be considered the backbone of your retirement savings. Contributions are easy because they automatically come out of your paycheck. Also, you may get an upfront tax deduction, and annual contribution limits are sizable — $18,000 for tax year 2015, plus a $6,000 catch-up for those who are 50 or older (both up $500 over 2014 limits).
That means, depending on your age, you could contribute up to $24,000 in 2015. And if you get an employer match, that’s extra savings in your pocket. Add tax-deferred growth of earnings and what’s not to like?
But as positive as all this is, there’s a good case for having an IRA in addition to your 401(k). An IRA not only gives you the ability to save even more but also may give you more investment choices than you have in your employer-sponsored plan. And if you have a Roth IRA, there’s also the potential for tax-free income down the road.
But the type of IRA that makes sense for you personally will depend on your filing status and your income, so there’s a bit more to consider.
Tips for Choosing the Type of IRA That’s Right for You
There are two types of IRAs: a traditional tax-deductible IRA and a Roth IRA. For 2014 and 2015, the annual contribution limit for both is $5,500, with a $1,000 catch-up if you’re 50 or older.
However, each IRA does have an income ceiling, which will determine whether one or the other is right for you.
–Traditional tax-deductible IRA. For someone who doesn’t have a 401(k) or similar plan, a traditional IRA is fully tax-deductible. Upfront tax deductibility and tax-deferred growth of earnings are two of the pluses of this type of IRA. However, if you participate in an employer-sponsored retirement plan — such as a 401(k) — tax deductibility is phased out at certain income levels. For tax year 2015, the levels are $61,000-$71,000 for single filers and $98,000-$118,000 for married people filing jointly.
–Roth IRA. With a Roth IRA, you don’t get any upfront tax deduction, but you do get tax-free growth, plus tax-free withdrawals at age 59 1/2, as long as you’ve held the account for five years. And there’s no restriction if you participate in an employer plan. However, there are income limits that determine whether you’re eligible to open and contribute to a Roth. In 2015, the limits are $116,000-$131,000 for single filers and $183,000-$193,000 for married people filing jointly.
There are a couple of other things to consider when choosing between IRAs, the main one being whether you believe you’ll be in a higher or lower tax bracket when you retire. That’s because withdrawals from a traditional IRA are taxed at ordinary income tax rates at the time of withdrawal; qualified Roth withdrawals, as I mentioned, are tax-free. Also, there’s no required minimum distribution for a Roth, but with a traditional IRA, you’ll have to begin taking an RMD at age 70 1/2.
A Roth 401(k) — Another Option Worth Considering
Whether or not you choose to open an IRA, if your employer offers a Roth 401(k), you might also consider adding this to your retirement savings strategy. There are no income limits to participate in a Roth 401(k), and you can have both types of 401(k) accounts at the same time. Having both doesn’t mean you can contribute more than the total annual 401(k) contribution limit, but you can split your contributions between the two, giving you a combination of both taxable and tax-free withdrawals come retirement time.
Making Your 401(k) and IRA Work Together
The goal of all this is to give you the greatest opportunity to save, with the greatest flexibility. So my thought would be to first contribute enough to your 401(k) to capture the maximum company match. Then, if you’re eligible — and especially if your 401(k) has limited investment options — open either a traditional or a Roth IRA and contribute the annual maximum. Next, if you can, put more money in your company plan until you max it out. And if you get to the point where you can save even more (kudos!), put that money in a taxable brokerage account.
The bottom line is you can’t really save too much, only too little. So use all the savings and investing vehicles available to you, including both an IRA and your 401(k), to save as much as you can, as early as you can — and, at the same time, get the maximum tax break. You won’t regret it.
Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER ™ is president of the Charles Schwab Foundation and author of “It Pays to Talk.” You can e-mail Carrie at email@example.com.