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Oct 24, 2017

What’s a Traditional IRA? All About This Retirement Savings Account

By Jeremy Quittner

A traditional IRA is different than a Roth IRA because you fund it with your pre-tax dollars.

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Congratulations! You’ve made the awesome decision to start planning for your retirement and are now the proud owner of a traditional IRA. Still have questions? We’re here to answer them.

Here’s a quick explainer about what a traditional IRA is and how it works:

What’s a traditional IRA?

A traditional IRA is an investment savings account with significant financial advantages. It lets you contribute money on a pre-tax basis until you turn 70 1/2. That means the money you put in comes from your gross income, and your contribution can lower your annual tax bill.

The money you’ve put away can then be invested in stocks, bonds, mutual funds, money market funds, ETFs and index funds, and other investments.  Your balance in the account can grow tax deferred through retirement, when you’ll pay taxes only on disbursements from the account.

How much can I put in my traditional IRA?

Good question. There are annual limits to what you can contribute. You can put up to $6,000 away each year. But once you’re age 50 or older, you can contribute up to $7,000 annually.

I still don’t get it, how does this work?

Okay, here are two easy examples. Let’s say you earn $50,000 annually. If you fully fund your IRA for the year up to your $6,000 limit, your IRA contribution can lower your taxable income to $44,000. Now let’s say you have less money to put away, maybe half that amount.

If you put $2,750 away, you could still lower your taxable income by that amount, to $47,250. In short, you could pay less income tax, and you’d be saving for your retirement at the same time. That could good deal.

When can I take my money out?

You can take money out of the account at any time, but before age 59½ you may have to pay a 10% penalty to the Internal Revenue Service (IRS), in addition to income taxes. For most people, that rate is around 20% for federal taxes. So, you could essentially lose close to a third of the value of the money you pull out early.

After age 59 ½, you can take money from the account with no penalties, although any money you withdraw you’ll have to pay income taxes on.

By age 70½ you’re actually required by the IRS to start taking money out of your account. This is called a required minimum distribution (RMD). (An RMD is based on a complicated formula based on a percentage of the total balance of the account and your life expectancy.)

If you don’t take your full RMD, you’ll also be hit with a steep tax of 50% on the difference between your RMD and what you’ve actually taken out each year.

Can I use my IRA money for anything else?

Yes, you can use up to $10,000 from your IRA to purchase a first home. That amount will not be subject to an IRS penalty of 10%, but you will have to pay income taxes on the money.

Other things to keep in mind:

Unlike with a 401(k), where your employer handles all the hard work and makes regular payroll deductions to your account, you’re responsible for funding your own IRA. You can do that in one lump sum each year, or via automatic monthly deductions from your bank account with your IRA provider.

Are you ready?

Get Stash Retire.

Jeremy Quittner is the editorial director for Stash.


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