If you’re eligible to contribute to an employer-sponsored retirement plan, should you? Should you contribute to an individual retirement account (IRA)? How about contributing to both? The answers are: Yes, yes, and yes. If this comes as a surprise, it’s probably because there are so many rules about eligibility for contributing to IRAs and workplace retirement plans that it’s easy to become confused about what is allowed and what isn’t.
But whatever rules there are, one thing is never ruled out: you can always contribute to both a workplace retirement plan – like a 401(k) or 457 plan – and an IRA, as long as you have earned income. What’s open to question are how much you can contribute, to which type of account, and whether your contributions are tax deductible. Keep these three important points in mind:
Point 1: There are limits to your annual contributions. Every year, the IRS sets limits on how much you can contribute to retirement plans, and the amounts are different for the different kinds of plans. The one rule common to them all is this: you can’t contribute more than your earned income (except for contributions to a spousal IRA for a spouse who does not work).
Let’s say your employer sponsors a 401(k) plan. If you participate in the plan by a) making contributions of your own, b) your employer makes contributions for you, or c) you and your employer both contribute to your account, then you can still contribute to your own IRA outside the workplace. If you’re 49 or younger, in 2012, you can contribute $17,000 to a 401(k) plan and another $5,000 to an IRA, for a total of $22,000 in retirement plan contributions. If you’re older, those numbers are $22,500 for the workplace plan and $6,000 for an IRA, for a total of $28,500.
Point 2: Your income can affect the tax treatment of IRA contributions. Originally, there was only one kind of IRA: the kind that enabled you to reduce your taxable income by the amount of your contributions. Today, it’s referred to as a “traditional” IRA, to distinguish it from a Roth IRA, to which you can only contribute after-tax money.
There are good reasons to choose either the traditional or Roth IRA, but if you participate in a workplace retirement plan and have income above the IRS limits, your ability to take the tax deduction for a contribution to a traditional IRA is limited. In 2012, tax deductibility begins to phase out if you’re a single filer and earn more than $58,000, and disappears altogether at $68,000. For joint filers, the ranges are higher: $92,000 to $112,000.
Take note, however: if you make too much to be eligible for the upfront income tax benefit in the year you contribute to a traditional IRA, you can still make contributions to it and to your workplace retirement plan. In this case, you might want to consider contributing to a Roth IRA instead. But here, too, you might be limited by income: for 2012, eligibility to contribute to a Roth IRA phases out for single filers with AGI above $110,000, and joint filers with AGI above $173. 000, and disappears completely for those earning more than $125,000 and $183,000, respectively. However, see the article “Converting to a Roth IRA” for details on how to contribute to a nondeductible IRA and then convert to a Roth IRA.
Point 3: Doing either can build assets faster– both, faster yet. The complexity of the rules regarding whether IRA contributions are tax deductible has obscured the most important benefits of qualified retirement plans: they compound free of annual taxes. This gives them a distinct advantage over taxable savings accounts, because at the same rate of return, assets grow faster when returns are not taxed.
For someone with an effective federal tax rate of 25%, an annual contribution of $5,000 to a taxable account that returns 6% a year grows to almost $223,000 in 25 years. But that same contribution to an IRA at the same rate of return grows to more than $274,000 – a difference of more than $50,000 regardless of whether the contributions were tax deductible. Increase the contribution to $20,000 a year, and the assets grow to nearly $1.1 million after 25 years – and the advantage over a taxable account exceeds $200,000. These examples are provided for illustration purposes only and are not intended to project the performance of a specific investment vehicle.
The bottom line: you should contribute as much as possible to tax-advantage retirement plans. For many people who work, there are multiple savings options available, including dividing your IRA contributions between both a traditional and a Roth IRA. There are even IRA options open for nonworking spouses. To make sure you’re taking full advantage of the options open to you, please call.
Copyright © Integrated Concepts 2012. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.