Over 60 million Americans understand the importance of having an IRA.  Thankfully, almost every American can establish an IRA, even if they have a 401(k) plan. More and more companies are offering their employees an option to save for retirement. However, just because you have a workplace plan, doesn’t mean you shouldn’t also save with an IRA as well.

This article will examine the different type of IRAs and offer suggestions as to when it makes sense to open.

IRA Basics

IRAs were created by ERISA in 1974 to incentive Americans to better save for retirement.  The two main features of IRAs that made them the most popular retirement vehicle are tax deductibility and tax deferral.  In general, contributions to a traditional IRA generate an income tax deduction, which lowers one’s tax liability.  Further, tax deferral allows the income and gains from one’s retirement plan investments to grow without tax. Taxes are only due when you withdraw from the plan.

What Income Can I Contribute to an IRA?

In general, compensation for purposes of IRA contributions is what one earns from working. Below are the most popular forms of compensation:

• Wages, salaries, etc.
• Commissions
• Self-employment income
• Alimony and separate maintenance
• Nontaxable combat pay

The following are several common forms of income that is not deemed compensation for purposes of the IRA contribution rules:

• Earnings and profits from property, such as rental income, interest income, and dividend income.
• Pension or annuity income.
• Deferred compensation received
• Income from a partnership for which one does not provide services that are a material income-producing factor.
• Any amounts (other than combat pay) one excludes from income, such as foreign earned income and housing costs

Traditional IRA

The traditional IRA is a pretax retirement account that anyone with earned income as outlined above can contribute to.  For 2023, the IRA maximum contribution amount stands at $6,500 plus an additional $1,000 “catch-up” contribution if you are at least age 50. Contributions to a traditional IRA are tax deductible. The deduction may be limited if you or your spouse is covered by a retirement plan at work and your income exceeds certain levels.

Distributions are subject to tax and a 10% early distribution penalty if you are under the age of 59 1/2 (unless a hardship can be satisfied). As of 2023, you must start withdrawing from your IRA once you turn age 73. Required minimum distributions must be satisfied each ensuing year.

Any self-employed individual with earned income can make contributions to an IRA. However, if one has access to a 401(k) plan at work and who earns more than $136,000 ($228,000 if spouse has access to a 401(k)) cannot make pretax IRA contributions.  If you nor a spouse has access to a 401(k) plan at work, there is no income limitation.

Read more: IRA Deduction Limits

Roth IRA

The Taxpayer Relief Act of 1997 introduced the Roth IRA. It is an after-tax IRA. As such, there is no immediate tax break. The income limits are the same for a Roth as they are for a traditional plan. In fact, many of the rules of the traditional IRA also apply to a Roth with a few exceptions.

The major difference is when you pay taxes. Taxes are deferred with a traditional IRA. You pay them when you distribute from the plan; taxes are due on both the contributions you have made and the income your investment generated. Because a Roth is funded with money that has already been taxed, you’ll never pay taxes again, assuming you follow two rules. First, you must have reached the age of 59 1/2. Second, any Roth IRA has to have been opened for at least five years.

Another benefit of the Roth is that there are no required distributions; you can let the money stay there, in full, for as long as you want. The benefit is that your investments will continue to grow undisturbed.

Lastly, there are restrictions as to who may directly contribute to a Roth IRA. If you earn too much money, you need to use a workaround, known as the Backdoor Roth IRA, to get funds into the plan. Having a workplace plan has no effect on your Roth contributions.

Opening an IRA when You Have a 401(k) Plan

The question then becomes, should you open an IRA even if you have a 401(k) plan through your employer? The answer is yes! The more you can save for retirement, the better off you will be (and the sooner you can retire!). The amount you contribute to your workplace plan does not limit your IRA contributions. Although, as we discussed earlier, the ability to receive a deduction might.

Experts agree on the best way to save for retirement using both an IRA and a workplace plan. The idea is to get the most out of your workplace plan if your employer offers a company match. Contribute enough to the plan so that you receive the full match. A typical match is 50% of your contributions up to 6% of your salary. That means if you make $50,000 annually, the company will match $3,000. To receive the full match, you must contribute twice that, or $6,000.

Once you’ve gotten all of that free money, the consensus says to then switch to funding an IRA. In the spirit of diversification, it’s recommended you go with a Roth. That way, you’ll have both a tax deduction (from your workplace plan) and tax-free growth of your IRA. Contribute as much as you can to the IRA, and if you are able to max it out, you can then switch back to your workplace plan and contribute up to the annual limit.

The other consideration is investment options. Workplace plans have a limited menu of investment options. Plan fiduciaries need to make sure the offerings of the plan are good for all employees. Plus, you don’t have the option to shop around for a better plan, which may have more choices and less fees. You get what you get. That’s not the case for an IRA.

You’re in control of where to open your IRA; after all, it’s an individual retirement account. Find the provider that offers the investments you want, and a price that’s fair. Obviously, we recommend checking out an IRA Financial Self-Directed IRA, which gives you the ultimate freedom to invest how and when you want.

Conclusion

IRAs, 401(k)s and other retirement plans are not mutually exclusive. The best savers take advantage of all available resources to save and invest. Just because you have $50 withheld from your paycheck every week doesn’t mean you’re good to go. Saving for retirement is not “set it and forget it” (although that would be great).

Retirement plans are the most tax-advantageous ways to invest. Each plan type comes with a unique set of benefits, whether it’s a company match, tax deduction, or tax-free withdrawals. So, yes, it’s highly recommended that you save with an IRA, whether or not you have a 401(k) plan. Speak with a financial advisor to determine what course of action is best for your unique situation. If you want to learn more about self-directing your IRA or other retirement plan, contact us.