Q: Everyone including my tax accountant says that you may contribute the maximum amount to a 401(k) plan, and then also contribute to a Roth IRA. If your employer does not offer a 401(k), you may contribute a much smaller maximum amount to a traditional IRA, but you may NOT then also contribute to a Roth IRA.
Is it true that you can contribute to both a 401(k) and to a Roth IRA, but not to a traditional IRA and a Roth IRA? And if that is true, what possible rationale is there for such apparently illogical and unfair rules? JC via email
A: You expect tax rules to be fair and logical?
Actually, there is a rationale for these rules, but you'll probably find it less than compelling.
Like most of us, you lump IRAs and 401(k) plans together as `retirement accounts'. But legally, they're in two distinct categories.
A 401(k) is a `qualified' retirement plan, which means that it meets the requirements of Internal Revenue Code Section 401(a), and is governed by the 1974 federal law known as ERISA.
An IRA is not a `qualified' retirement plan -- which simply means that it doesn't have to meet 401(a) requirements, and it's not subject to ERISA.
The annual contribution limits are per category, not per account. You can invest the category maximum in one account, or you can divide it between two accounts within that category. But you can't inflate the annual limit by contributing the maximum to two accounts in the same category.
Or to put it another way, you can contribute the maximum to both a 401(k) plan and a Roth IRA because the two are in different categories. The 2010 maximum 401(k) contribution is $16,500 ($22,000 if you're 50 or older.) The maximum 2010 Roth IRA contribution is $5,000 ($6,000 if you're 50 or older.)
Theoretically, that means you can save up to $21,500 (or $28,000) by contributing to both. But in real life, even if you can afford it you can't salt away that much.
In the first place, most employers cap the amount their highest-paid workers can contribute to the 401(k) to less than the law allows. That's right: A 401(k) plan can never be more generous than the law; but it can always be more restrictive.
(Why the cap? So the plan will be sure to pass a federal anti-discrimination test. A 401(k) flunks the test if a company's higher-paid workers save disproportionately more of their pay than its lower-paid workers. If that happens, the employer must either return some of the higher-paid workers' contributions or dig into its own coffers to add to the lower-paid worker's contributions.)
In the second place, you may earn too much to contribute the maximum to a Roth IRA. In fact, if you can afford to contribute the maximum, you probably do earn too much:
If you're single, you can't contribute the maximum to a Roth IRA if you earn more than $105,000 a year. If you're married filing jointly, you can't make the maximum contribution if you earn more than $167,000. If you earn over those limits, the rules gradually 'phase out' the size of your permissible contribution until it disappears. If you're single and make more than $120,000, or are married filing jointly and earn more than $177,000, you can't contribute to a Roth IRA at all.
I know what you're thinking: What about all the hoopla advertising how Roth IRAs are now finally available to everybody regardless of income?
All that hoopla is about converting a traditional IRA to a Roth IRA, which you couldn't do until this year if your household income exceeded $100,000. Roth IRA conversions are now available to everyone. But the limits on Roth IRA contributions haven't change.
You can contribute to both a traditional IRA and a Roth IRA, provided you meet their respective age and income requirements.
To contribute to a traditional IRA, you must be under 70 and a half, and you must have earned income. (Whether or not the contribution is tax-deductible is a subject for another day. It's based on a fiendishly complex rule that depends both on your annual income and on whether you or your spouse participates in an employer-sponsored retirement plan.)
You can contribute to a Roth IRA at any age; but you must have earned income, and it can't exceed the limits. (See above.)
If you're fully eligible for both accounts, you must split the maximum annual IRA contribution between them. In other words, your total 2010 combined contributions to a traditional IRA and a Roth IRA cannot exceed $5,,000 ($6,,000 if you're 50 or older).
A combined limit rule also applies to Roth 401(k) contributions, which federal law has permitted since 2006. In other words, if your company's 401(k) plan allows both regular and Roth contributions, your combined limit for both would be $16,500 (or $22,000) -- subject to your employer's restrictions, of course.
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