If You Have a 401(k), Do You Need an IRA, Too?

Dear Carrie,

I already have a 401(k). Does it make sense to open an IRA, too?

—A Reader

Dear Reader,

A 401(k) or other 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; you may get an upfront tax deduction; and annual contribution limits are sizeable—$19,500 for tax-year 2020, plus a $6,500 catch-up for those age 50 or older (both up $500 over 2019 limits).

That means, depending on your age, you could contribute up to $26,000 in 2020. Plus, 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, it might also 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 2020, the annual contribution limit for both is $6,000 with a $1,000 catch-up if you're age 50-plus.

However each IRA does have an income ceiling that 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 plus 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 based on your Modified Adjusted Gross Income (MAGI). For tax-year 2020, the levels are $65,000-$75,000 for single filers, $104,000-$124,000 for married 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 59½ 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 phase-out limits based on your MAGI that determine whether you're eligible to open and how much you can contribute to a Roth. In 2020, the limits are $124,000-$139,000 for single filers, $196,000-$206,000 for married 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 (RMD) for a Roth, but with a traditional IRA, you'll have to begin taking an RMD at age 70½, or 72 if you were born on or after July 1, 1949.

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) 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 contribute to a tax-advantaged Health Savings Account (HSA). If your 401(k) has limited investment options consider opening 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.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.

Please note: This article may contain outdated information about RMDs and retirement accounts due to the SECURE Act 2.0, a law governing retirement savings (e.g., the age at which individuals must begin taking required minimum distributions (RMDs) from their retirement account will change from 72 to 73 beginning January 1, 2023). For more information about the SECURE Act 2.0, please read this article or speak with your financial consultant. (1222-2NLK)