3 Reasons a 401(k) Deferral Beats an IRA Contribution
1) There Are No Restrictions Preventing a Tax Break
When you defer a portion of your salary into a traditional 401(k), the amount deferred will reduce your taxable income dollar-for-dollar. This is true regardless of how much income you (and your spouse, if applicable) have. In contrast, contributions to a traditional IRA are generally entitled to a tax deduction as well, but if your income is above certain limits and you (and/or your spouse, if applicable) are an active participant in an employer-sponsored retirement plan, then that deduction can be reduced or eliminated. Thus, in some scenarios, a contribution to a traditional IRA won’t help you reduce your current tax bill.
2) You Can Contribute a Lot More
For 2017, you can contribute up to a $5,500 to a traditional IRA. If you are 50 or older by the end of the year, the contribution limit increases by $1,000, known as a catch-up contribution, to give you the potential to contribute up to $6,500. Putting $6,500 aside each year for your future can really add up overtime and help you build up a sizeable nest egg, but the 401(k) can supersize that. In 2017, the 401(k) salary deferral limit is $18,000, and if you are 50 or older by the end of the year, you can contribute up to $24,000. Putting that much away a year can really add up quickly.
3) Reduces Modified Adjusted Gross Income (MAGI) for Roth IRA Contribution Purposes
If you make a deductible contribution to a traditional IRA, that contribution will lower your income for income tax purposes, but it will not help reduce your income for Roth IRA contribution eligibility purposes. That’s because the modified adjusted gross income (MAGI) calculation that determines whether or not you can contribute to a Roth IRA requires that you add back in any IRA deduction. That doesn’t work the same for 401(k) contributions. When you defer a portion of your salary into a 401(k), those contributions reduce your income for both income tax purposes and for Roth IRA contribution eligibility. Put differently, putting money into a 401(k) could take you from an income level where you’re prevented from making a Roth IRA contribution to an income level where a full or partial contribution is allowed.
Your Tax Break May be More Immune to the Trump Tax Proposal
Recently, the Trump administration announced its tax plan. The plan was scant on details. It did, however, allude to the elimination of deductions for items other than charitable contributions and real estate. If that were to come to pass, then the tax break for making an IRA contribution could be eliminated. Now you might ask, “Wouldn’t that be the same for 401(k) contributions?” While that may appear to be the case at first glance, it may not necessarily be the case. IRA contributions lower your income by means of a deduction. In contrast, 401(k) contributions are excluded from your gross income to begin with. Technically, that’s not a deduction. It’s a subtle difference, but it could ultimately prove to be very important. Of course, until there’s more information about the widely anticipated tax reform package than can be written on the back of a napkin, it’s somewhat speculative to suggest this potential difference.