Dear Kirk: Does it make sense to contribute to a traditional IRA if you can’t benefit from the tax deduction because you’re already covered by an employer-sponsored 401K? And if so, why?
Kirk Says: This question is all about tax consequences, so let’s spend some time understanding what is at stake here. First, let’s make an assumption that your employer offers a qualified plan as a benefit to you, the employee. This assumption means that any contribution to a Traditional IRA is not tax deductible.
Now let’s make an additional assumption that your employer offers you free money in the form of a matching contribution to the qualified plan.
For example, your qualified plan is a 401K plan. Your employer offers a dollar-for-dollar match for up to 3 percent, and your annual salary is $40,000. In this instance, you should contribute the 3 percent and maximize the employer match. By doing this, you will have saved $1200 of your own money for the year, received a company match (free money) of $1200, and reduced your taxable income for the current year to $38,800. All of these things are good for you, the employee. But it’s important to also take long-term consequences into account.
Other factors to consider are the tax rate that you currently pay and the tax rate that you may be responsible to pay years down the road when you retire. You must manage the risk of whether you expect tax rates to be higher for you when you retire than they are now—or vice versa. If you believe they are certain to be higher when you retire, then the Roth makes more sense. If you believe you will definitely be in a lower tax bracket when you retire, then the qualified plans and traditional IRA make more sense.
Another way to think about it is this: You would never borrow money from a lender that said, “We will lend you the money, but I can’t tell you the rate of interest. We will charge you right now, but we will let you know later when we figure out how much money we need.” But that is essentially what the IRS and the federal government are saying to those of us who participate in qualified plans.
So back to our original question. Take your employer’s free money! But after that, you should look to maximize a Roth IRA account, if you believe in a higher tax outlook for the future.
Now let’s gain an understanding of how the Roth works. You contribute after-tax money to the Roth, and as long as you play by the Roth rules, the money invested grows tax-free, and you will be able to receive all of your money tax-free when you pull it out in retirement.
If your belief is that you will be in a lower tax bracket when you retire, then you should maximize your 401K plan and contribute to a traditional IRA, which will grow tax-deferred. But make no mistake, you will pay taxes similar to the qualified plans when you start to pull the money out in retirement.
To summarize, a balanced approach is advisable, because none of us can predict the future. Furthermore, much like a fingerprint, our financial situations are entirely unique to the individual, so it is important to spend time consulting with a financial advisor to gain the resources to make the right decision for you.
Kirk Gwaltney is a Chartered Financial Consultant and a Chartered Life Underwriter in Brentwood, Tenn. Learn more about him at kirkgwaltney.com.