Can You Fund a 401k and an IRA?

Woman praying at computer

Here’s a classic retirement question from a reader:

I’m in my 30’s, and saving about 10% of my salary. Soon I can contribute to my 401k—and they’ll match 100%, up to 5% of my salary. Should I put the whole 10% into my 401k and stop contributing to my IRA, or do both?

OK, there are a few things to think about here, but let’s concentrate on taxes.

When you contribute to a 401k—or a traditional IRA—you get a similar tax benefit: i.e. the amount you save in each isn’t counted as taxable income. In other words, it’s income, but it’s not taxed.* At first.

The money you save is tax-deferred—so when you withdraw the money (in years to come) you pay taxes on it then.

But what if you put 5% in your 401k to get the full match (a.k.a. free money) and then put the other 5% into a Roth IRA?

The advantage of a Roth IRA is that you’re putting in cash that you’ve already paid tax on. So Uncle Sam cuts you a break—and when you retire you don’t pay tax on any Roth withdrawals.

Crazy-time. But true. By the way, the limit you can save in an IRA or Roth is $5,500 for 2013 ($6,500 if you’re 50 or older). You can contribute for 2012 up until tax day, April 15, 2013.

It’s probably wise to keep some part of your retirement money tax-free, since no one knows what tax rates will look like down the line. Assuming you don’t exceed the income limits, it’s likely a good idea to take advantage of a Roth, whether you have a 401k or not.

*Except that in some cases, when you put money into both an IRA and 401k, you may not be able to deduct your full IRA contribution.