What Is A Traditional IRA And How Does It Work?
6-minute readJanuary 28, 2021
Many employers offer 401(k) plans to help their employees save for retirement. If yours doesn’t or you don’t think it and Social Security will be enough to support you and your family during your retirement years, you’ll need to be saving on your own to grow your nest egg. This is where a traditional IRA (individual retirement account) can come into the picture.
What Is A Traditional IRA?
Traditional IRAs are retirement accounts that first became available in 1975 after Congress passed the Employment Retirement Income Security Act of 1974. One of the major perks of having a traditional IRA is that you can invest with pretax dollars.
So what does that mean?
It means that every contribution you make throughout the year can be deducted from your taxable income. But that doesn’t mean you’re never going to pay taxes on the account. Instead of being taxed upfront, you’ll be paying taxes when you withdraw money in retirement. But for now, a traditional IRA is a great way to reduce your tax bill.
Traditional IRAs are widely available. You can open an account through your bank, with a broker or even through a robo-advisor.
How Does A Traditional IRA Work?
Once you’ve opened a traditional IRA account, you’ll need to select your investments. There are a lot of options available. You can invest in stocks, mutual funds, ETFs, CDs and even real estate.
If you prefer a more hands-off approach, robo-advisors are a great way to go. When you open your account, they’ll ask you a few questions to determine how much risk you’re willing to take on. They’ll use that information to select an investment portfolio that’s a good fit.
Because traditional IRAs are tax-advantaged accounts, the federal government has put limits on how much you can actually save each year. In 2020, the traditional IRA contribution limit is $6,000. However, if you’re over the age of 50, they’ve added an extra $1,000 and bumped the limit to $7,000.
Another important aspect to understand about traditional IRAs is that even though you’re allowed to deduct contributions from your taxes, these deductions phase out based on income if you or your partner have a qualified retirement plan through your employer as well. If you’re not covered by a workplace plan, then you’re allowed to deduct 100% of your contributions no matter what your income might be.
If you’re covered by a workplace plan, you’re allowed a full deduction if you fall into either of these two groups:
- You’re single or you file head of household and your modified adjustable gross income (MAGI) is $65,000 or less.
- You file married filing jointly and your MAGI is $104,000 or less.
Additionally, if you’re married and file jointly and your spouse has a workplace retirement plan, the income limits are different. You’re allowed a full deduction if your MAGI is $196,000 or less.
One of the larger downsides to a traditional IRA is that they have required minimum distributions (RMDs). You’re required to start taking distributions by April 1 the year after you turn 72. If you fail to take this distribution in any year, a 50% penalty is assessed. To put this into a dollar amount, let’s assume you have a RMD of $10,000 but you forgot to take the distribution. The IRS will charge you a penalty of $5,000 for that year.
Now let’s assume you find yourself in a position where you need to access funds from your IRA. If you haven’t reached age 59 1/2, you’ll pay taxes on the distribution as well as a 10% penalty. There are a few exclusions to the early distribution penalty, including purchasing a home, birth or adoption of a child, higher education costs and medical expenses.
Pros Of Using A Traditional IRA
Everyone knows that saving for retirement is extremely important. But with all the different retirement products available, it can be difficult to know what’s right for you. To help simplify things, here are some of the pros of using a traditional IRA.
- No income limits to open or contribute. It doesn’t matter if you make $20,000 per year or $300,000. Anyone is allowed to open and contribute to a traditional IRA.
- Contributions are deductible. When you contribute to a traditional IRA, your contributions are deductible, up to a specific income limit.
- Tax-deferred growth. Any gains you make are not realized and taxed until they are withdrawn during retirement.
- Pay for college expenses. You can use your traditional IRA account, without penalty, to pay for higher education for yourself or any dependents. There is no limit to the amount you can use. Just keep in mind that you’ll pay taxes on whatever you withdraw.
- Purchase a house. You’re allowed to withdraw up to $10,000 for the purchase of a home. You’ll pay taxes on the amount but no penalties.
Cons Of Using A Traditional IRA
Unfortunately, traditional IRAs aren’t perfect for everyone. They do have some drawbacks that you should consider before opening an account.
- Contribution limits. There are limits to the amount you’re allowed to contribute each year. For tax year 2020 the contribution limit is $6,000 unless you’re 50 years or older, when you can contribute $7,000.
- Required minimum distributions. Once you reach age 72, you’re required to start taking distributions even if you don’t need the money in retirement.
- Income limits on deducting contributions. If you or a spouse are covered by a retirement plan through an employer, your ability to deduct traditional IRA contributions starts to phase out at specific income levels.
- Penalties for early withdrawal. If you withdraw money from your traditional IRA before you reach age 59 1/2, a 10% penalty will be assessed if the withdrawal isn’t a covered exclusion.
Traditional IRA Vs. Roth IRA: What’s The Difference?
Throughout this article, we’ve talked exclusively about traditional IRAs. However, they aren’t the only IRA option available to someone looking to save for retirement.
Roth IRAs, which are a much newer product, introduced as part of the Taxpayer Relief Act of 1997, has quickly become a popular choice for many Americans. The biggest difference between a traditional IRA and a Roth IRA is the way they’re taxed.
Traditional IRAs are tax-deferred, which means they aren’t taxed until you make withdrawals. With a Roth IRA, you’re taxed today, and then when you go to withdrawal money in retirement, you won’t pay any taxes on the gains.
So who might want a traditional IRA vs. a Roth IRA? If you think you’ll be in a higher tax bracket during retirement than you are today, a Roth IRA might make sense. You’ll get taxed at today’s lower rate and withdraw tax-free at your higher retirement tax bracket. However, if you think you might be at a lower tax bracket in retirement than you are today, it might make sense to take advantage of the current tax deduction that comes with the traditional IRA.
In addition to the way they are taxed, Roth IRAs also have income limits for who can invest. If you’re single and make less than $124,000, you’re allowed to invest up to $6,000 in 2020 ($7,000 for age 50 and above). If you’re married filing jointly, you’re allowed to invest the same amount if your MAGI is less than $196,000. Once your income is greater than $124,000 as a single filer or $196,000 when filing married filing jointly, your eligibility will phase out until you’re no longer allowed to invest in a Roth IRA when your income is $139,000 or more as a single filer and $206,000 or more when filing married filing jointly.
Finally, unless you inherit a Roth IRA, they don’t have required minimum distributions as a traditional IRA does. That means if you don’t need the money during part of your retirement, you can keep it invested.
Does A Traditional IRA Fit Your Retirement Plan?
Saving for retirement from an early age is important if you want to have a large enough nest egg available. But before you get started, it’s important to educate yourself so you know what’s going to be best for your situation.
If your plan includes an IRA, you need to start by determining which makes more sense for you, a traditional IRA or a Roth IRA. For many of us, it’s tough to know what our earnings might be over the next 20, 30 or 40 years. But do your best to imagine (realistically) what it could look like. Would you be better off being taxed today or when you’re ready to start taking distributions? What if you have a 401(k) or a pension plan through your employer? Would that be enough to live on during the first part of your retirement?
Before you make a decision on how you’ll save for retirement, it’s important to weigh your options. Ask yourself some of these questions, and you’ll have a better understanding of where you should be putting your money to work.
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