It is important that you contribute as much money to your retirement fund each year as possible. Most savvy savers put their money into an IRA or a 401k. Is it possible to put money into both accounts each year? The good news is that the answer is yes — but there’s a catch.
Your IRA And 401k Are Separate Retirement Vehicles
First, lets take a look at the two different types of accounts.
- An IRA is an individual retirement account that allows you to save up to $5,500 per year if you are under the age of 50. If you are over the age of 50, you are allowed to save as much as $6,500 a year starting in 2013.
- Your 401k is an employer sponsored retirement plan that allows you to contribute a portion of your pre-tax income toward your retirement. The maximum amount that can be contributed to a 401k is $17,500 in 2013.
What Are The Tax Consequences Of Investing In Both A 401k And An IRA?
Investing in both a 401k and an IRA allows you to maximize your tax savings in a given year. Lets say you made $50,000 last year. If you contributed 3 percent of your income to a 401k, you would reduce your taxable income by $1,500 for the year resulting in a gross adjusted income of $48,500.
Assuming a marginal tax rate of 15 percent, you would be left with a tax bill of $10,700. If you put $5,000 in a Traditional IRA, you would reduce your tax bill by 15 percent of $5,000. This saves you another $750 on your tax return. Overall, you reduced your tax bill by $2,250 just by saving for your retirement.
However, you can decide to pay the taxes upfront by opting for a Roth IRA and/or a Roth 401k. Those who elect this option will pay the full amount of income tax in the year in which the contribution is made. However, your contributions and any gains accrued over the life of the account will be made available tax-free during retirement. Choosing this option can be a good idea if you expect to be in a higher tax bracket after you retire.
So, What’s the Catch?
Here’s where the rules can get a little tricky. Do you or your spouse participate in an employer covered retirement plan? If so, your tax deduction for any contributions made to a Traditional IRA may be limited. How fun, right?
This Traditional IRA deduction limit is based both on how much money you earn and your tax filing status for the year. In layman’s terms, the more money you make, the less of a deduction you can claim. If your income is higher than a certain amount, then you would unfortunately not be qualified to receive a deduction for your Traditional IRA contributions.
Traditional IRA Deduction Limits (if also contributing to a 401k)
Please note, the below information is relevant for the 2012 tax year.
- Singles/Heads of Household: If you make less than $58,000 in 2012, you qualify for the full deduction. If you make between $58,000 and $68,000, your tax benefit is phased out as a partial deduction. If you make more than $68,000, you do not qualify for a deduction in the 2012 tax year.
- Married Filing Jointly: If you make less than $92,000, you will qualify for the full tax deduction. Income between the range of $92,000 and $112,000, you would receive a partial deduction. And, finally, if you make over $112,000 in 2012, you would not be eligible for the deduction.
Something To Think About If You Are Self-Employed
If you work for yourself, you may think that you cannot contribute to a 401k. However, this is not true. Self-employed individuals who do not have employees can sign up for a Solo 401k. This plan allows you to contribute as both an employee and an employer. On the employee side, you can contribute 100 percent of your wages up to $17,500.
On the employer side, you can contribute up to 20% of all wages paid assuming that the total amount is less than $49,000. It doesn’t matter what business structure is used, it is still possible to contribute to an IRA. A Roth Solo 401k is available for those who don’t mind paying taxes on their retirement income immediately in exchange for a much more likable tax burden (zero percent) during retirement.
Should You Invest in Both an IRA and a 401k?
If you are thinking of ways to maximize your retirement contributions this year, you should seriously think about contributing to your IRA as well as your 401k. Doing so will bolster your retirement fund, potentially save money on your taxes, and the money will accrue interest for the rest of your life.
Just make sure you fall within the income requirements to receive that dandy deduction. If not, you may want to consider looking into a Roth.