Most of us like simplicity in life, and that even includes retirement planning. If you actively participate in the 401(k) plan with your employer, you may assume that you’ve got your retirement covered. But as the saying goes, never assume anything. Investing in an individual retirement account (IRA) is an opportunity to supplement your 401(k) plan and your retirement in general. There are a number of reasons why you would want to do this. No matter how good a 401(k) may look on the surface, you can always do better, and an IRA is one way to make that happen.
401(k) Contribution Limits
The Internal Revenue Service (IRS) allows 401(k) contributions of up to $17,000 per year ($17,500 for 2013), but an employer may impose limits that are considerably lower. For example, your employer can cap your contributions at a certain dollar amount, or as a percentage of your income.
If your employer’s contribution ceiling is $10,000, you’ll never come close to the IRS allowable maximum. Likewise, if your employer contributions stop at 15% of your income, and you earn $50,000 per year, your maximum contribution will be limited to $7,500.
If your employer’s 401(k) contribution maximums are considerably lower than what the IRS allows, you may not be saving enough money for your retirement. You can make up some of the shortfall with your own IRA.
With an IRA, you can contribute up to $5,000 per year ($5,500 in 2013), and make an additional contribution of $1,000 if you’re age 50 or older. If the most you can contribute to your employer’s 401(k) plan is $7,500, the addition of a $5,000 IRA contribution will increase your annual retirement contribution total to $12,500 per year.
Even if your IRA contribution is only partially tax-deductible, or not deductible at all, you will still be able to accumulate investment earnings on your contributions on a tax-deferred basis. In the fact, that any or all of your IRA contribution is not deductible can be an advantage all its own. More on that in a minute.
More Investment Choices
Many employer-sponsored 401(k) plans put limits on your investment options, sometimes severely. They may offer a money market fund, half a dozen mutual funds or exchange traded funds (ETFs) and an option to purchase company stock. Many times in fact, the employer contribution match is given in company stock.
Those investment options may be adequate, but won’t give you a whole lot of choice, especially if your own investment goals are heading in another direction.
With an IRA by contrast, you have a virtually unlimited number of investment options. Since IRAs are completely self-directed, you can choose the trustee or brokerage firm where the account will be held, and that will give you all the options you need.
Income Tax Options
Remember a bit earlier we said that a nondeductible IRA contribution can have advantages all its own? Money that you contributed to an IRA that did not provide you with a tax deduction in the year that it was made can be withdrawn tax-free. Since no tax deduction was taken for the contribution, there is no tax on the withdrawal. There will only be tax on the accumulated earnings on the contributions.
You can take this a step further with a Roth IRA. With the Roth IRA your contributions are not deductible in the year they’re made, so there is no tax on the withdrawal. But Roth IRAs have an even better feature. As long as you are at least 59 ½ at the time of withdrawal, and you have the account open for at least five years, any withdrawals from the account will be tax-free.
Since 401(k) contributions are tax-deductible in the year that they’re made, 100% of your withdrawals from the plan will be taxable. IRAs can offer a tax diversification at retirement. Whether it’s for withdrawal of nondeductible IRA contributions, or from a Roth IRA account, IRAs will allow you to withdraw at least some money at retirement on a tax-free basis. This will lower your taxable income in retirement at least partially, and that‘s something a 401(k) plan can never do.
Never Put All of Your Eggs in One Basket
When it comes to retirement it’s never a good idea to rely on a single income source. By putting at least some money into an IRA, you will have an investment income source in addition to your 401(k) plan. Those, along with Social Security and any pension you might have, will give you the income diversification and you need.
In addition, since IRAs have greater investment options, you also have an opportunity to put at least some of your money into investments that you never can with a 401(k). Those investments could prove to be some of the best ones that you make your lifetime, and will be a nice supplement to your main savings in your 401(k).
Do you have an IRA, in addition to a 401(k) plan?