Why to contribute to both a 401(k) & an IRA: Savings & tax benefits

Two of the most popular retirement savings accounts are the 401(k) and individual retirement account (IRA). How do you choose between the two? Good news—you don't have to!

Because they have different structures and rules, it can be confusing to determine where to invest your retirement savings. You may wonder, "Can I contribute to a 401(k) and an IRA at the same time?" You can own both types of tax-advantaged accounts simultaneously, and, depending on your situation, it could be a smart move.

Here are some factors to consider about supplementing a 401(k) with an IRA.

First, a quick review of the options.

• A 401(k) is an employer-based plan that you fund through payroll deductions. If your company matches your contributions, that additional money can help further boost your nest egg.
• An IRA, specifically traditional and Roth IRAs, are accounts you can open through a financial institution such as a bank or brokerage firm.

Diversification, the practice of spreading your assets among numerous investments, can reduce the impact of market volatility and other risks. Thrivent's Retirement Readiness Survey* found that among those nearing retirement, 42% intend to rely on a mix of assets such as a 401(k), IRAs, personal savings and Social Security benefits. Only 21% of the younger generations of savers have a similar strategy.

It's never too early to start diversifying your retirement accounts. Maintaining both a 401(k) and IRA is a great first step, especially since both offer tax-advantages and the benefit of compound interest.

Here are three reasons that contributing to both a 401(k) and IRA may be right for you:

You can contribute a lot more to a 401(k) each year than an IRA. Funding both simultaneously can help you put more away toward retirement.

• 401(k): Up to $22,500 ($30,000 if you're 50 or older)
• IRA: Up to $6,500 ($7,500 if you're 50 or older)

• 401(k): Up to $23,000 ($30,500 if you're 50 or older)
• IRA: Up to $7,000 ($8,000 if you're 50 or older)

Contributing the maximum to both retirement accounts can be difficult for many people to afford. You might want to consider waiting to fund an IRA until after you've maxed out your 401(k) contributions or at least taken full advantage of your company match.

An IRA gives you the flexibility to include many kinds of assets such as:

• Stocks
• Bonds
• Mutual funds
• Certificates of deposit (CDs)
• Real-estate investment trusts (REITs)
• Money market funds

With 401(k) plans, you may be limited to a preselected menu of investment options. These investment options typically include things like mutual funds or exchange-traded funds (ETFs). For many people, not having to choose from the entire pool of investments the market offers can be a good thing. But some more experienced investors may prefer to have more options.

The two main types of IRAs, traditional and Roth, are taxed differently. These different tax structures create unique considerations when you also contribute to a 401(k).

A Roth IRA is funded by money that you've already paid taxes on, so withdrawals of your contributions are tax-free at any time. While there is no tax deduction for Roth IRAs, your earnings grow tax-deferred in the account, and if you make a qualified withdrawal, those earnings can be withdrawn tax free.¹ These factors make it a tax-efficient way to help minimize your tax liability in retirement.

Roth IRAs have income limits to participate based on your modified adjusted gross income (MAGI).

• If you make between the maximum MAGI listed, you can contribute but it will be a reduced amount.
• If you make equal to or more than the maximum limit listed, you can't contribute anything to a Roth IRA. If this applies to you, check out these alternatives.

If you meet the income requirements, contributing to a 401(k) and Roth IRA simultaneously can help diversify your tax liability due to the different tax treatment of the withdrawals (and the Roth IRA benefit for the potential for tax-free earnings).

With a traditional IRA, your money grows tax-deferred over time. And you will defer paying taxes until you withdraw funds. The benefit of tax-deferral is that it gives your money the potential to grow and compound over a longer period of time.

You may be able to deduct your traditional IRA contributions on your taxes. That is certainly true if you and your spouse don't participate in an employer-sponsored plan like a 401(k). If you contribute to a 401(k), however, your traditional IRA contributions would be tax-deductible only if your MAGI is below certain income thresholds.

• If you make below the MAGIs listed, you can make a full tax deduction of your contributions.
• If you make between the maximum MAGI listed, you can make a partial deduction of your contributions.
• Although you still can contribute to an IRA, you will not be eligible for the tax deduction if your MAGI exceeds the top of the MAGI thresholds.

A required minimum distribution (RMD) is the minimum amount you must withdraw from qualifying retirement plans once you reach a specific age. You'll pay income taxes on the distributions.

• If you turn 73 before 2033, your RMD age will be 73.
• If you turn 74 after 2032, your RMD age will be 75.

A traditional IRA has RMDs that you have to make at your RMD age.

A 401k plan also has RMDs, but may offer a delayed distribution as part of the plan and not require RMDs until termination of service (this option does not apply if you are a 5%+ owner of the business and RMDs will be required in that case).

So, if you own both a 401(k) and traditional IRA, you may need to take multiple RMDs in the same year. While you are likely to enjoy the extra income, it can pose a complication: RMDs are taxed at your current income, so the additional income from your distributions could potentially push you into a higher tax bracket.

Roth IRA owners, however, don't need to take RMDs (although they may be required for beneficiaries.) And starting in 2024, owners of Roth 401(k)s will not be subject to RMDs going forward. That means you can leave the money in those accounts to continue to grow and compound as long as you'd like.

• Not familiar with Roth 401(k)s? Read "Roth 401(k) vs traditional 401(k): What's the difference?"

Funding both a 401(k) and an IRA—or even both versions of IRAs—could help maximize your savings ahead of retirement. To make the most of your strategy, consider working with a financial advisor who can guide you through your different account options, their related regulations and how each might fit into realizing the future you envision for yourself and your family.