Because both traditional IRAs and 401(k)s permit clients to contribute funds using pre-tax dollars and are taxed similarly upon withdrawal, many clients may mistakenly believe that funding a 401(k) is the same as funding an IRA and vice versa.
This is, of course, false. The IRS imposes restrictions on which clients are eligible to fund various types of accounts, and the rules vary both the plan contribution limits and the benefits associated with funding either of the two types of retirement plans.
The average client who is not intimately familiar with the detailed retirement account rules might easily be faced with a classic chicken vs. egg dilemma—which account to fund first, the 401(k) or the IRA? Providing informed advice as to the pros and cons of each option gives the advisor an important opportunity to add value to the client's retirement while avoiding unpleasant tax surprises down the road.
401(k) vs. IRA Funding Rule Basics
The information that is likely most well-understood by clients involves the pre-tax contribution limits that apply with respect to IRAs and 401(k)s. In 2019, eligible clients can contribute up to $6,000 to their IRA (an additional $1,000 if age 50 or older) and $19,000 to their 401(k) (with an additional $6,000 catch-up option). Unlike the case with other types of qualified plans, the IRA contribution limits do not intersect with the 401(k) rules—meaning that, if otherwise eligible, the client can contribute the maximum to both types of account.
After this, we delve into slightly murkier waters. Not every taxpayer is eligible to contribute to both a 401(k) and an IRA, even if they have the available funds. The "active participant" rules limit IRA contributions for taxpayers who have actively participated in a 401(k) (i.e., contributed) to those clients whose income hasn't exceeded certain thresholds for the year.
For 2019, if the client is an active participant, IRA contributions phase out for single taxpayers with modified adjusted gross income of between $64,000 and $74,000 and for joint returns reflecting MAGI of between $103,000 to $123,000. For married taxpayers where one spouse is an active participant, the phase-out range for the non-active participant spouse increases to between $193,000 and $203,000.
Roth IRAs impose similar restrictions on high-income taxpayer contributions, but also provide for tax-free growth and withdrawals. Roth 401(k)s may also be available if the employer provides the option.
