Opening and Contributing to Both 401(k) And Roth IRA

It is possible to open and utilize both 401(k) and Roth IRA at the same time.

Before understanding how to manage both a 401(k) and Roth IRA, it is helpful to understand the features of a 401(k) and a Roth IRA.

What Is a 401(k)? 

A 401(k) is a type of retirement savings plan which allows employees to save for retirement on a tax-deferred basis. Generally, the maximum contribution limit an employee can contribute to his own 401(k) account is $18,000 annually. Employers are allowed to match 50 percent or 100 percent of their employees’ contributions up to $18,000 annually. 

This means that if an employee contributed $10,000 into his own 401(k), then the company would then contribute another $5,000 at the most. It is important to note that this doesn’t mean employers always match 100 percent of their employees’ contributions.

For example, say an employee contributes $5,000 into his 401(k) account and the company matches 50 percent of his contribution up to $2,500.

What Is a Roth IRA?

A Roth IRA is an individual retirement account that allows individuals to save for retirement on a tax-deferred basis. Individuals who are interested in the Roth IRA are not taxed at the time of deposit but are later taxed upon withdrawal.

The primary benefit of a Roth IRA is that your account grows tax-free until you withdraw the money.

The main difference between a Roth IRA and a 401(k) is that contributions to a Roth IRA are made on an after-tax basis, while contributions to 401(k) plans are pre-tax (you don’t pay taxes now).

Additionally, contributions to a Roth IRA are not limited by your entire income like the 401(k) plan.  For example, if your earned income is $75,000 and you choose to contribute $18,000 of that income into your 401(k), then the employer would match 50 percent of the contribution up to $18,000.

If your earned income is too high to allow you to contribute the maximum amount allowed into your 401(k), then you are not eligible for a Roth IRA at all.   

Maximizing Both Roth IRA and 401(k)

In order to maximize the benefits of both a 401(k) and a Roth IRA, contributions should be made at least to the extent that all applicable contribution limits are satisfied.

For example, if an individual has a 401(k) plan with his employer where he could contribute up to $18,000 ($24,000 if 50 percent match is available) and he is also eligible to contribute up to $5,500 ($6,500 if age 50 or over) into a Roth IRA if his income falls below certain limits, then he should make at least the maximum 401(k) contribution.

Doing so allows him to contribute $23,500 ($18,000+$5,500) to retirement accounts in the same year.  If he contributes $24,000 into his 401(k), then he can only contribute $3,500 (the contribution limit for Roth IRA is $5,500 if age 50 or over) into a Roth IRA.

This individual should also note that even though traditional and Roth IRAs have different contribution limits, this does not mean he can contribute $5,500 to his Roth IRA and $5,000 to his 401(k).  Contributions are made on an individual basis. 

Therefore, if he contributed $24,000 into his 401(k), the most he could contribute into his Roth IRA is $500 ($5,500-$24,000).

This means that if he were to contribute the entire 401(k) contribution limit of $18,000 into his traditional IRA, then it would reduce his ability to contribute enough money into the Roth IRA to meet its annual contribution limits.

The Bottom Line

Both a 401(k) and a Roth IRA can be great retirement planning tools.  However, in order to maximize the benefits of both plans, individuals should understand how they work and how much to save into each account if their income is high enough for them to have access to both accounts.

In order to do this, it may be helpful to work with a financial advisor who can help an individual understand his/her options and develop a comprehensive retirement savings strategy that is best suited for their particular needs.

The primary advantage of a Roth IRA is that its funds can be withdrawn tax-free later in life. This differs from the traditional IRA, where contributions are tax-deductible upfront, but any withdrawals are taxed at ordinary income rates.
A person can contribute to both a Roth IRA and an employer-sponsored 401 (k).
Withdrawals on earnings can be made at any time. Pre-59 ½ penalties do not apply to this account.
No, you can only have one type of IRA at a time.
A qualified withdrawal includes any funds being withdrawn from your account for reasons including, but not limited to, purchasing your first home, higher education expenses for yourself or a dependent, disability, or death.

401(k) Plan | A Complete Beginner's Guide

401(k) Meaning

The 401(k) retirement savings account got its name from the Revenue Act of 1978, where an addition to the Internal Revenue Services (IRS) code was added in section 401(k). Consequently, 401(k) does not stand for anything except for the section of IRS tax code it was created in.

Traditional 401(k) vs Roth 401(k)

There are two types of 401(k) plans: Traditional and Roth 401(k)s. The traditional 401(k), named after the relevant section of the IRS code, has been around since 1978. With this plan, any contributions you make to the 401(k) account will reduce your income taxes for that year and will be taxed when they are withdrawn. Roth 401(k)s, named after former senator William Roth of Delaware, were introduced in 2006. Unlike a traditional 401(k), all contributions are made with after-tax dollars and the funds in the Roth 401(k) account accrue tax free. Typically, employees can take advantage of both plans at the same time, which is recommended among financial advisors to maximize retirement savings. Because of the way the contribution limits work, it is possible to invest different amounts into each account, even year-to-year, so long as the total contribution does not exceed the set limit.

Contributing to Your 401(k) Retirement Plan

Contributing to a 401(k) plan is traditionally done through one’s employer. Typically, the employer will automatically enroll you in a 401(k) that you may contribute to at your discretion. If you are self-employed, you may enroll in a 401(k) plan through an online broker, such as TD Ameritrade. If your employer offers both types of 401(k) accounts, then you will most likely be able to contribute to either or both at your discretion. To reiterate, with a traditional 401(k), making a contribution reduces your income taxes for that year, saving you money in the short term, but the funds will be taxed when they are withdrawn. With a Roth 401(k), your contributions can be made only after taxation, which costs more in the short term, but the funds will be tax free when you withdraw them. Because of this, deciding which plan will benefit you more involves figuring out in what tax bracket you will be when you retire. If you expect to be in a lower tax bracket upon retirement, then a traditional 401(k) may help you more in the long term. You will be able to take advantage of the immediate tax break while your taxes are higher, while minimizing the portion taken out of your withdrawal once you move to a lower tax bracket. On the other hand, a Roth 401(k) may be more advantageous if you expect the opposite to be true. In that case, you can opt to bite the bullet on heavy taxation today, but avoid a higher tax burden if your tax bracket moves up. Check out this article from Forbes to see the IRS tax rate tables for 2020, but remember that they are subject to change. A smart move may be to hedge your bets and divide your contributions between the two types of IRAs. If your employer allows you to add funds to both a traditional and Roth 401(k), then doing so reduces the potential risks of each. In this case, you will also have the ability to decide what proportion of your income goes into each account, meaning that as you near retirement and have a clearer idea of what position you will be in, you can put more into one or the other. When you do decide which avenue to take, make sure to thoroughly evaluate your decision. Moving funds from one account to another, such as from a traditional to a Roth 401(k), is time consuming and expensive, if even possible. Likewise, transferring a 401(k) from one employer to another in the event of a job change is also tricky. You want to make sure that when you put money into your plan, it will be able to sit undisturbed for a very long time.

Pension vs 401(k)

Pensions are similar to a 401(k), but are a liability to a company. If an employer offers an employee a pension, it means that they are promising to pay out a set amount of money to the employee at the time of their retirement. There is typically no option to grow this amount, but it also does not require any financial investment from the employee. Pensions, also referred to as defined-benefit plans, are becoming increasingly rare because it puts the financial burden of offering a retirement fund for employees entirely on the employer. 401(k)s, which are also called defined-contribution plans, take some of the financial pressure off of an employer, while also allowing employees to potentially earn a larger retirement package than they would have with a pension.

How Much Should I Contribute to My 401(k)?

Most financial experts say you should contribute around 10%-15% of your monthly gross income to a retirement savings account, including but not limited to a 401(k). There are limits on how much you can contribute to it that are outlined in detail below. There are two methods of contributing funds to your 401(k). The main way of adding new funds to your account is to contribute a portion of your own income directly. This is usually done through automatic payroll withholding (i.e. the amount that you wish to contribute, counting all adjustments for taxation, is simply withheld when receiving payment and automatically put into a 401(k)). The system mandates that the majority of direct financial contributions will come from your own pocket. It is essential that, when making contributions, you consider the trajectory of the specific investments you are making to increase the likelihood of a positive return. The second method comes from deposits that an employer matches. Usually employers will match a deposit based on a set formula, such as 50 cents per dollar contributed by the employee. However, employers are only able to contribute to a traditional 401(k), not a Roth 401(k) plan. This is especially important to keep in mind if you want to utilize both types of plans. A key variable to keep in mind is that there are set limits for how much you can add to a 401(k) in a single year. For employees under 50 years of age, this amount is $19,500, as of 2020. For employees over 50 years of age, the amount is $25,000. If you have a traditional 401(k), you can also elect to make non-deductible after-tax contributions. The absolute limit, counting this choice and all employer contributions, is $57,000 for employees under 50, and $63,000 for those over 50 as of 2019.

Plan in Advance

Allow us to help you prepare and plan for your retirement ahead. Contact a financial advisor in St Helena, CA or visit our financial advisor page for other details.

401(k) Plan FAQs

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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