Aug 25, 2022
What Is a Traditional IRA?
A traditional IRA is a tax-advantaged individual retirement account that allows you to invest on a pre-tax basis, meaning you don’t pay income tax on the money when you invest it. Your balance can grow tax-deferred, and when you withdraw it after you reach retirement age, you’ll pay taxes on qualified account disbursements. One of the biggest advantages of a traditional IRA is that it can lower your annual tax bill when you make contributions.
One thing to keep in mind: a traditional IRA is an investment account, not a savings account at a bank. There’s risk involved in all investing, including the risk that you could lose money.
In this article, we’ll cover:
How traditional IRAs work
A traditional IRA is an investment account that helps you save for retirement and reap tax advantages at the same time. You open an account and contribute funds, which can be invested in stocks, bonds, mutual funds, money market funds, exchange-traded funds (ETFs), and other securities. Your investments grow tax-deferred, which means you don’t pay taxes on your earnings until you withdraw the funds.
The money you put into a traditional IRA is a tax deduction, meaning you can subtract it from your gross income when you file your taxes. For example, let’s say you earn $50,000 annually. If you put $6,000 into your IRA in a given year, your contribution could lower your taxable income to $44,000.
You’re also allowed to contribute post-tax dollars to a traditional IRA too; your earnings will grow tax-deferred either way.
Once you reach age 59½, you can start taking withdrawals from your account; you’ll pay income tax on your contributions and earnings at that time.
The annual contribution limit to a traditional IRA is $6,000, as of 2022. If you’re 50 or older, you may make an additional $1,000 catch-up contribution, for a total of $7,000 annually. One caveat: if you earn less than the contribution limit, you can only contribute up to the total of your taxable income for the year.
Traditional IRA contributions are made with pre-tax dollars, so you can deduct them from your taxable income. Doing so might put you in a lower tax bracket or make you eligible for certain tax incentives.
If you don’t have an employer-sponsored retirement plan, such as a 401(k), you can deduct the entire amount you’ve contributed for the year.
However, the amount you can deduct may be limited if you have an employer-sponsored retirement plan and earn over $68,000. And if you’re married, your deductions may be lowered if your spouse has an employer-sponsored plan, even if you don’t.
Generally, you can start taking funds out of your traditional IRA when you turn 59½, and you’ll pay regular income tax when you make withdrawals.
If you take out money early, however, you’ll usually have to pay a 10% penalty on top of income tax. There are a few exceptions to the IRA early withdrawal rule, including:
- becoming totally and permanently disabled
- paying for certain higher education expenses
- buying your first home, up to $10,000
- paying health insurance premiums while unemployed
Once you turn 70½, you’re generally required to start taking withdrawals from your traditional IRA each year. The required minimum distribution (RMD) is calculated by dividing the IRA account balance as of December 31 of the prior year by the applicable distribution period or life expectancy.
How traditional IRAs differ from other IRAs
There are several different types of IRAs, both for individuals and employees. The terms of each differ based on eligibility, contribution limit, income limit, tax treatment, and a few other factors. The comparison chart below reflects information as of 2022 for four common types of IRAs.
|Key differences||Traditional IRA||Roth IRA||SIMPLE IRA||SEP IRA|
|Who’s it for||Individuals||Individuals||Employees||Employees/Individual|
|Eligibility||No age limit to begin contributing.|
Must earn an income of at least the amount of total contributions
|No age limit to begin contributing.|
Must earn an income of at least the amount of total contributions
|No age limit to begin contributing. |
An employer can’t have any other retirement plan
|Must be 21 or older|
Must have worked for the business in at least 3 of the last 5 years
Must receive at least $650 in compensation during the year
|Income limit||No income limit||$144,000 if single or $214,000 if married and filing jointly||$305,000/year||$305,000/year|
|Contributions||Pre-tax money||After-tax money||Pre-tax money||Pre-tax money|
|Contribution limits||$6,000/year||$6,000/year||$14,000/year||$61,000/year or 25% of compensation (whichever is less)|
|Catch-up contributions||$1,000/year if age 50+||$1,000/year if age 50+||$3,000/year if age 50+||None|
|Qualified withdrawal taxes||Taxed at your income tax rate||Tax-free||Taxed at your income tax rate||Taxed at your income tax rate|
A Roth IRA is similar to a traditional IRA in many ways: it’s an individual retirement account that offers tax advantages as long as you leave your money in it until you turn 59½. The main difference between a traditional and a Roth IRA is when the money is taxed. With a Roth IRA, you pay income tax on money before you invest it. Then, when you make qualified withdrawals, you don’t pay any income tax at all, including on the money your account has earned. You’re also allowed to withdraw funds you’ve contributed at any time without penalty, though you’ll be subject to a 10% penalty if you withdraw earnings early.
The Savings Incentive Match Plan for Employees, or SIMPLE IRA, allows an employer to set up traditional IRAs for their employees; both the employer and employee can make contributions. It’s generally available for small businesses with fewer than 100 employees that don’t have another retirement savings plan, like a 401(k). If your employer offers a SIMPLE IRA, they’re required to contribute a certain amount each year, but you don’t have to put in any money.
The Simplified Employee Pension Plan, or SEP IRA, is a retirement account that can be established by either an employer or a self-employed person. Unlike the SIMPLE IRA, only an employer can contribute to a SEP IRA. The employer is allowed to take a tax deduction for contributions made, and they must contribute equally to all eligible employees. Note: if you’re self-employed, you are considered the employer, so you can make contributions and take tax deductions.
If you have an employer-sponsored retirement plan and leave your job, you can usually do what’s called a rollover, in which you transfer the funds into an IRA. Most people are eligible to roll over funds into either a traditional or Roth IRA, but there can be tax implications if you’re rolling over pre-tax money into a Roth IRA. If you’re trying to decide what to do with your 401(k) or 403(b), you may want to brush up on the IRS rules for rollovers.
Pros and cons of contributing to a traditional IRA
Traditional IRA benefits
An IRA of any kind can help you put away money for retirement and possibly enjoy tax advantages. The particular benefits of the traditional IRA include:
- Your tax-deductible contributions can lower your taxable income for the year, and may even drop you into a lower tax bracket.
- You pay no taxes on funds while they’re invested, meaning there’s more money in the account to compound over time.
- If you’re in a lower tax bracket when you make withdrawals than when you made contributions, you may pay less tax on your money overall.
- You can invest in a wide variety of securities, including stocks, mutual funds, and ETFs.
- There’s no income limit; you can put money into a traditional IRA no matter how much you make.
Disadvantages of traditional IRAs
Depending on your circumstances, there may be some downsides to a traditional IRA compared to other types of IRAs, including:
- Penalties for early withdrawals
- Limits on yearly contributions
- Required minimum distributions after age 70½
- Possible limits on tax deductions if you or your spouse have an employer-sponsored retirement plan
Is a traditional IRA right for you?
The sooner you start investing for the future, the more time your money has to grow. When you’re deciding whether a traditional IRA is a right choice for you, you might consider things like:
- Flexibility: Are you able to leave your funds in your account until retirement age to avoid incurring penalties?
- Tax deductions: Do you want to lower your tax bill now or pay less tax in the future?
- Income limits: Do you make enough money that you’re not allowed to open a Roth IRA?
When it comes to tax-advantaged individual retirement accounts, people are often weighing the pros and cons of a traditional IRA vs. a Roth IRA. Good news: you can have both.
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