There’s considerable flexibility about using an IRA or Roth IRA, even if you have a workplace retirement plan in place. Just be careful to follow the rules.
Those with workplace retirement plans are allowed to put money into an IRA (Individual Retirement Account). Whether or not you can take a deduction depends on your income level. For example, if a 23-year-old single woman contributes the maximum $18,000 to her Roth 401(k) at work in 2016, and her employer matched $9,000, is she allowed to make a tax-deductible contribution to an IRA?
Kiplinger’s article, “Deducting an IRA Contribution on Your Tax Return,” reminds us that anyone who participates in a 401(k) or other retirement plan at work is also able to contribute up to $5,500 to an IRA. The IRS gives you until April 18 to make a contribution for the past year.
However, a contribution to a traditional IRA may or may not be tax-deductible. Because the 23-year-old single in our example, is covered by a retirement plan at work, she is only allowed to deduct her traditional IRA contribution, if her modified adjusted gross income (AGI) for 2016 was less than $71,000 (because she's single). This deductible amount begins to phase out when a person’s income is $61,000 or higher. However, there’s no maximum income limit for deducting traditional IRA contributions, if you aren't covered by a 401(k) or other retirement plan by an employer.
Married individuals covered by a retirement plan at work are allowed to deduct their traditional IRA contributions, if their joint income was less than $118,000 in 2016. The deduction starts to phase out at $98,000. If you weren’t covered by an employer’s retirement plan but your spouse was, your IRA contributions can be tax-deductible, if your joint income in 2016 was less than $194,000 (the deduction amount starts to phase out at $184,000). There's no maximum income limit for making tax-deductible contributions, if neither spouse is covered by a work retirement plan.
Even though the 23-year-old single in our example is eligible to deduct traditional IRA contributions, she may want to contribute to a Roth IRA instead. She can’t deduct Roth IRA contributions (and her Roth 401(k) contributions are also after taxes), but the money grows tax-free for retirement. She can also withdraw her contributions without a penalty or taxes at any time. Since she's young, and her income will likely increase over time and push her into a higher tax bracket, the benefit of tax-free growth in the Roth IRA is likely to be better than the benefit of receiving a tax deduction for traditional IRA contributions now.
Studies have shown that, especially for younger investors, Roth IRAs result in much more after-tax money during retirement than traditional IRAs. If tax rates increase in the future, the Roth will be beneficial, and it has no required minimum distributions (RMDs) after you turn 70 ½.
The most important thing for people just starting out in their careers to keep in mind, is that time is on their side. By starting to save and invest for retirement in their early twenties, they have all of the advantages of building a healthy retirement nest egg over an extended period of time.
Reference: Kiplinger (February 3, 2017) “Deducting an IRA Contribution on Your Tax Return”