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Retirement Planning > Retirement Investing

Which Retirement Account Comes First, the 401(k) or the IRA?

By William H. Byrnes By Robert Bloink

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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.

How to Allocate Limited Funds?

When both IRA and 401(k) options are available to the client and it is not possible to max out both types of account, it becomes important to examine some of the more detailed rules that apply to provide benefits with respect to either type of account beyond the pure tax-deferral issue.

First, and perhaps most important to most clients, is the employer match issue. When an employer provides a matching 401(k) contribution based upon the employee’s contribution, the first available dollars should usually be allocated to the 401(k), at least in an amount sufficient to take advantage of the match. From this point, most clients will consider the value of diversifying between types of accounts to take advantage of a Roth feature, whether in the form of a Roth 401(k) option or Roth IRA, to provide for tax-free income during retirement.

The client’s goals with respect to retirement timelines are also important. For example, penalty-free distributions may be available from a 401(k) as soon as age 55 if the client retires (i.e., “separates from service”)—and the client can continue working past the age when required minimum distributions (RMDs) begin to apply and avoid RMDs from the 401(k) in most cases.

IRAs, on the other hand, require the client to reach age 59 ½ to take a penalty-free distribution unless some other exception applies (such as a first-time home purchase or certain educational expenses), and the client must begin to take RMDs upon reaching age 70 ½.  401(k)s can also provide access to funds in the form of loans, whereas IRAs do not have a loan option. IRAs, however, are more portable—while the client must usually take active steps to move the 401(k) to consolidate accounts when changing jobs, the IRA is established independently of the employer.

Of course, investment options offered (and fees charged by) either type of account, as well as the client’s desire to invest in non-traditional account assets such as real estate or precious metals, which can be accomplished through an IRA, also need to be taken into account.  The need for asset protection can also come into play in some cases.

Conclusion

What’s best for any given client with access to both 401(k) and IRA options generally requires a detailed examination of the client’s particular circumstances and individual preferences.  Taking a wholistic approach and examining all relevant issues will serve to increase the odds that the client will maximize limited retirement savings dollars over the long-term.

William H. Byrnes

Robert Bloink

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