Can You Open An IRA If You Already Have A 401k?

I spent two years not opening an IRA because I had a 401k and assumed the 401k used up my allowance. Nobody told me otherwise and I never thought to ask.

It does not.

An IRA, an individual retirement arrangement, is an account you open yourself at a broker, in your own name, with nothing to do with your employer. A 401k is the plan your employer runs and contributes to through payroll.

They carry separate contribution limits. Having one open does not close the other, and you can fund both in the same year if you have the money.

The one thing a 401k changes

Being covered by a workplace retirement plan can limit whether a traditional IRA contribution is tax deductible, once your income passes a certain band. That is the whole of it.

Deductible and allowed are two different words and people run them together. Three questions are hiding inside the one everybody asks.

1. 01Am I allowed to put money into an IRA at all? Almost certainly yes, if you or your spouse has earned income from work.
2. 02Do I get a tax deduction for it this year? That depends on your income, and only if you or your spouse is covered by a workplace plan.
3. 03Can I use a Roth IRA instead? That depends on your income too, on a completely separate band, and it has nothing to do with the 401k.

Traditional or Roth, in one paragraph

A traditional IRA may give you a deduction the year you contribute, grows untaxed, and is taxed as income when you take it out. A Roth IRA gives you no deduction, grows untaxed, and comes out tax free if you meet the rules.

Say you contribute $7,000 and you are on a 22 per cent marginal bracket. A full traditional deduction on that is $1,540 off this year's tax bill, because 7,000 times 0.22 is 1,540. The Roth version costs you that $1,540 today and hands you a balance you never pay income tax on again.

That is a bet on your own future tax rate against your current one, and nobody can settle it for you with certainty.

What a phase-out is

A phase-out is a band of income across which a benefit shrinks from full to zero, rather than cutting off at one number. Earn a dollar over the bottom of the band and you do not lose everything, you lose a proportional slice.

The income measured is your MAGI, modified adjusted gross income, which is your income after certain adjustments are added back in. For most people with a salary and not much else it is close to their total income, but it is not identical to the number on your payslip.

There are two separate bands and confusing them is the most common error I see. One governs the traditional deduction when a workplace plan covers you. One governs Roth contributions and applies whether you have a 401k or not.

What to do with your row

Below the band, both doors are open and the choice is the tax bet described above. Deduct now at today's rate, or pay now and never pay again.

Inside the band, you get a partial deduction and a reduced Roth allowance, and the formulas are genuinely annoying. Most brokers will calculate the reduced Roth figure for you during the contribution flow, and the deduction is worked out on your return.

Above the top of the band, a traditional contribution is still allowed but you get nothing for it this year, which is a strange place to sit. There is a second step people take from there, and it has one rule that quietly ruins it for a lot of people.

The order almost everyone gets wrong

None of this comes before an employer match. If your employer puts in 50 cents for every dollar you do, up to 6 per cent of salary, that is $2,400 a year on an $80,000 salary, because 80,000 times 0.06 is 4,800 and half of that is 2,400.

Take the match first. It is a 50 per cent return on the money in the year you contribute it, and there is no IRA, no fund and no strategy that competes with that.

After the match, the IRA is usually the next place to look, because the fund menu is the entire market rather than the nine options your plan administrator picked.

The step people forget after funding it

Money moved into an IRA is not invested. It lands in a cash position inside the account and sits there until you buy something with it, and brokers are not always loud about that.

I know two people who contributed diligently for three years and then discovered the entire balance sitting in cash. Fund the account, then place the trade. Those are two separate actions and only the first one is automatic.

Find this year's phase-out bands, find your MAGI from last year's return as a starting estimate, and work out which row you are in. If you land above the top of both bands, the next thing to understand is the pro-rata rule, because it is the reason a lot of high earners end up with a surprise tax bill on a move they were told was free.