Building a nest egg is the goal of every hard-working employee. It provides financial security and guarantees you a comfortable retirement. But if you have invested beyond the amount allowed in your workplace retirement plan, can you put money into an IRA?
You can contribute a maximum of $6,000 a year into an IRA even after maxing out your 401(k) through a traditional or Roth IRA. Their tax benefits enable your investment to compound quickly. Also, an IRA allows you to qualify for a deduction since maxing your 401(k) lowers your taxable income.
This article will discuss how an IRA works, the different types, and how you can contribute to one despite maxing out your workplace 401(k), so keep reading.
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How Does an IRA Work?
An IRA or Individual Retirement Account is a tax-advantaged savings and investment vehicle geared towards life after retirement. Like a 401(k), your IRA savings grow tax-free until you retire from active work.
The thing is, when you contribute to a traditional IRA, you are eligible to receive a tax deduction for the amount contributed per year. This means that your IRA contributions help reduce your taxable income.
For instance, if you contribute $6000 in 2021, you can claim this amount on your tax return, thus reducing your 2021 taxable income by $6,000.
However, your IRA contribution may not qualify for a deduction if you or your spouse have a 401(k). To determine your eligibility or what portion of your contribution you can deduct, you need to check IRA income limits.
Nonetheless, even if you don’t qualify to make a deduction, it’s still possible to make nondeductible IRA contributions.
Contributing To an IRA After Maxing Out 401(k)
If you’re wondering how to contribute to an IRA after making the maximum contribution to your 401(k), there are two primary ways to do this. Plus, you can put in up to $6,000 every year and $7,000 if you’re 50+ years. To contribute to an IRA, you can either fund a traditional IRA or fund a Roth IRA.
I’ll discuss each of the options.
Traditional IRA for Early Tax Deductions
This is an account that provides tax deductions for eligible individuals saving towards retirement. You make pre-tax contributions, your investments grow tax-deferred, and you pay income tax on withdrawals upon retirement.
As such, any taxes you would pay on your gains get deferred to a later date. But if you make a withdrawal before retirement (except for college fees or home purchase), the withdrawn amount attracts a 10% penalty.
While anybody earning an income can contribute to a traditional IRA, not all are eligible to deduct their contributions. This is because your tax deductibility depends on specific income limits and participation in a workplace retirement savings plan.
For instance, if you have a 401(k), it might minimize your ability to deduct IRA contributions or eliminate them if your income level is higher than the set limits.
For married people, qualified widows and widowers, or those filing jointly, the income limit range lies between $105,000 and $125,000. However, an IRA contributor – without a 401(k) plan – married to someone covered by one cannot qualify for the deduction if their combined income is between $198,000 and $208,000.
To start a traditional IRA, you can open an account at a brokerage and invest in assets like stocks and bonds for your retirement. You can also use Robo-advisers, automated technology that helps you select investments best suited to your financial goals. If you go through a bank, you get Certificates of Deposit or a savings account.
Roth IRA for a Tax-Free Investment Growth
Roth IRA is a retirement account that offers you tax-free investment growth. In 2021, the contribution limit is also $6,000 or $7,000 if you are older than 50. These limits apply to modified adjusted gross incomes under $140,000 for single filers and $208,000 for married couples filing jointly.
The money you use to fund a Roth IRA is already taxed. As a result, any contributions made to other funds do not limit the amount you can put in here. Furthermore, you can deduct the entire IRA contribution amount from your gross income if you or your spouse also contribute towards a workplace retirement plan, like the 401(k).
Therefore, you can contribute to a Roth IRA if:
- You are a couple, pay joint taxes, and your modified adjusted gross income falls below $208,000.
- You are single or filing separately and earn below $140,000.
The great thing about investing in a Roth IRA is that your money grows tax-free. Also, when you eventually withdraw it in your retirement, it won’t undergo taxation. However, if you are 59½ years old and have held your account for a minimum of 5 years, you can make withdrawals without incurring federal taxes.
One thing to note, though, is that if your income is above IRS limits ($186,000), you might not be eligible for one of the traditional IRA tax benefits.
Differences Between a Traditional and Roth IRA
The differences between the two types of IRA mainly focus on tax deductions, eligibility criteria, and accessibility of funds. One significant difference between a traditional IRA and Roth IRA is that with a Roth IRA, you make your contributions using the money you have already paid taxes on.
In other words, your contributions are tax-exempt (you already paid the tax upfront). However, upon retirement, your withdrawals become tax-free. This means that if you meet Roth IRA conditions, you can avoid paying taxes on your investment earnings.
The other difference is that while Roth IRA has no required minimum distributions, you must start taking distributions at 72 years with a traditional IRA. In addition:
- Your contribution to Roth IRA is not tax-deductible – but your withdrawals at retirement are tax-free.
- If you make withdrawals from your traditional IRA, you attract income taxes on the amount withdrawn, but this does not apply to withdrawals from Roth IRA.
- Unlike a traditional IRA, a Roth IRA account doesn’t offer you a tax deduction in the year you make your contribution.
Should You Choose a Traditional or Roth IRA?
Choose Roth IRA if you’ll likely be in a much higher tax bracket come retirement, especially if you already have other investments. Otherwise, choose a traditional IRA if you think your tax bracket will be lower in retirement.
Individuals who choose to go with Roth IRA will get to pay their taxes at a lower rate now and withdraw tax-free funds after retiring from work. For those who choose the traditional IRA, however, they can enjoy tax benefits now while in a higher bracket and pay lower taxes in their sunset years.
Another advantage of the Roth IRA is that it imposes few restrictions on retirees. You can leave your savings to continue increasing tax-free for as long as you want. Unlike traditional IRA, there is no requirement to start taking minimum distributions upon hitting 72 years of age.
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Conclusion
As we have seen, you can continue building your retirement fund after maxing your 401(k) by funding an IRA. Contributing to an IRA not only increases your retirement savings and lowers your tax burden, but your investment grows faster since it’s devoid of tax. Ultimately, your goal should be to minimize your tax liabilities while maximizing your earnings.
But whether you choose a traditional IRA or Roth IRA, the most important thing is to ensure that you contribute the maximum amount every year to make the most of your IRA investment.
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