Pushing Boundaries: Investing in 401(k)s and IRAs at the same time

So you want to take your retirement savings to the next level by investing simultaneously in a 401(k) retirement plan and an Individual Retirement Account (IRA)? Call me impressed! You can do it but, as with everything else in life, you have to abide by some rules. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Where to Begin?

It is entirely appropriate to contribute to a Roth IRA and/or a traditional IRA even while contributing to a 401(k) plan at work. Let’s first talk about the “proper” order of things by working through an example.

Let’s suppose that your goal is to save 12% ($12,000) of your gross income in this 401(k) AND... wait for it.... an IRA retirement savings account. Here's how to do it.

Being financially astute, let's assume you have properly set aside a Rainy Day fund and that your salary is not encumbered with expensive credit card debt. Let’s next assume that you make $100,000 of earned income per year, and that your employer offers a 401(k) plan and has agreed to match up to 6% of your contributions.

The 401(k) Option

Because it involves FREE MONEY, the best place to start saving for retirement is to invest sufficient funds in your 401(k) account to nab your employer’s 6% matching contribution ($6,000).

The employee contribution limit to a 401(k) in 2021 is $19,500 or $26,000 if you're age 50 or over. Any employer match that you receive does not count toward this limit. The employer and employee combined 401(k) contribution limit in 2021 is $58,000 or $63,500 for those aged 50 or older.

The IRS does limit how much of an employee’s compensation is eligible for a 401(k) match. In 2021, the compensation limit is $290,000. For example, if an employee makes $400,000 and the company matches 4% based on the employee’s 401(k) contribution, the employer can only contribute $11,600 (4% of $290,000) instead of matching the full amount.

By the way, do not be shortsighted and count your employer’s 6% as part of the 12% you plan to save annually. Based on that piece of advice, you still have another 6% of your gross income to invest.

Now comes your second important decision. If your 401(k) is a Roth…and if you’re happy with its investment options…then by all means invest the rest of your 6% savings there. However, note that while your contribution goes into a Roth 401(k) and is not taxable upon withdrawal, your employer's contribution to a Roth 401(k) is placed into a traditional 401(k) plan, and it is taxable upon withdrawal.

If your employer only offers a traditional 401(k), then it’s time to consider one of those wonderful Roth IRAs outside your company retirement plan.

The Roth IRA Option

Because a Roth IRA lets you enjoy both tax-free growth within the plan today and tax-free withdrawals in retirement, it’s a great complement to your traditional 401(k) retirement plan. And it’s a great place to invest the remaining 6% ($6,000) of your retirement contributions. If you’re over 50, you can invest an additional $1,000 of catch-up contributions and still be within the IRA’s maximum annual contributions.

The maximum annual contribution to an IRA in 2021 is $6,000 or $7,000 if you're over 50. And the contribution must be “earned” income. Contributions to a traditional IRA are tax-deductible depending on your income. And your income will affect how much money – if any – can be contributed to a Roth IRA. The annual contribution limits to both Roth and traditional IRAs are $6,000 plus the catch-up mentioned earlier, and can be shared by the two accounts, but the total contribution limit is still $6,000 or $7,000. By the way, the two do have different rules regarding contributions.

Traditional IRA contributions are often tax-deductible. However, if you are covered by a 401(k) or other employer-sponsored plan, your modified adjusted gross income (MAGI) will determine how much of your contribution you can deduct. For example, if your tax filing status is SINGLE and if your income is less than $66,000, you can take a full deduction. If your income is between $66,000 and $76,000, you can take a partial deduction. If your income is over $76,000, no deduction is allowed.

Because Roth IRAs provide no upfront tax benefit, having an employer plan doesn’t matter. How much you can contribute, if any, is based on your tax-filing status and your annual income. Again, using a SINGLE tax filing status, income for a full contribution must be $125,000 or less. For a partial contribution, income between $125,000 and $140,000. No contribution is allowed if your income is more than $140,000. To summarize:

Participating in a 401(k) at work doesn’t affect your eligibility to make IRA contributions.
But your “traditional” IRA contributions are deductible – or not – depending on your income.
And your income will affect how much money – if any – you can contribute to a Roth IRA.

By the way, you could have chosen to divide this remaining $6,000 between a Roth and a traditional IRA, but why bother? The allure of tax-free money in retirement is a beautiful thing; thus, I ignored the traditional IRA option (despite the tax-deductibility of initial contributions).

One Step Further

Should you decide to save more than 12% of your salary in 2021 (and because you’ve maxed out your contributions to IRAs for the year), you can return to your Roth 401(k) and make additional contributions there…up to the $19,000 limit, plus the 50+ catch-up amount if you qualify.

In Sum

So, there you have it!

Put $6,000 (6%) of your salary in a Roth 401(k)
Plus $6,000 (6%) of employer matching funds invested in a traditional 401(k);
Then another $6,000 (6%) of your salary in a Roth IRA;
And finally, more investments in the Roth 401(k) should you decide to save more than 12% of your gross salary all within the contribution limits of the various retirement accounts.