What Is a Traditional IRA?

Definition and Examples of a Traditional IRA

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A traditional IRA (individual retirement account) is an investment account that offers tax-advantaged retirement savings. Contributions to a traditional IRA are tax-deductible, although you must pay tax on withdrawals in retirement.

Learn how contributions, tax deductions, and withdrawals work for a traditional IRA and whether it's the right choice for you.

What Is a Traditional IRA?

A traditional IRA is an investment account used in addition to or in place of an employer-sponsored retirement account to save for retirement. It's an account that you hold individually, in your own name.

Contributions are made to a traditional IRA on a pre-tax basis. Provided that you qualify for a full deduction, you can deduct that amount from your taxable income when you deposit money into the IRA. This results in paying less income tax for the year.

In addition to receiving a valuable tax deduction, the money in the account grows tax-deferred. Any interest or capital gains from the investments aren't taxed the way they are when dividends are received in a taxable brokerage account. Instead, taxation is deferred until money is withdrawn from the IRA in retirement.

Withdrawals from a traditional IRA are taxed at your income tax rate at the time of the withdrawal. If you expect to be in a lower tax bracket when you retire, you might owe less in taxes on your qualified IRA withdrawals than you would if you paid tax on that income now. 

Alternate names: traditional individual retirement account, traditional individual retirement arrangement

How a Traditional IRA Works

Anyone with earned income is eligible to contribute to a traditional IRA. Contributions for the year must be made by your tax filing deadline, usually April 15 of the following year, not including filing extensions.

Before 2020, anyone age 70 1/2 or over was no longer eligible to contribute to a traditional IRA even if they had earned income. This rule was eliminated on Jauary 1, 2020.

You can open a traditional IRA through a brokerage, mutual fund company, or even at your local bank, and the money you contribute can be invested in stocks, bonds, mutual funds, CDs, and other investments. Different funds will have different balances of investments, allowing you to choose an IRA that:

  • Has an appropriate mix of stocks and bonds based on how close you are to retirement
  • Has investments that align with your values

Many financial institutions offer target-date retirement funds. These funds generally start out more aggressively and risky, giving you the potential to earn more when you're younger and have time to recover from potential setbacks. As you get closer to retirement, the balance of investments held in the account automatically becomes more conservative.

You can choose to contribute occasionally to your IRA, or you can set up regular contributions that are added every month. Contributing every month allows you to take advantage of dollar-cost averaging, which accounts for fluctuations in the market over time.

For many savers, the amount that you contribute each year can be claimed as a deduction when you file your taxes for that year.

How Much Can I Contribute to a Traditional IRA?

The maximum contribution you can make to all your IRAs, including both traditional and Roth IRAs, is $6,000 in 2020 and 2021. You can contribute up to $7,000 if you're age 50 or older.

You can't contribute more than your earned income if your total earned income for the year was less than the maximum contribution limit

The contribution limit does not apply to rollover contributions.

The higher amount for older savers is known as a catch-up contribution for those who are closer to retirement age. That allows you to gain ground in your retirement saving efforts if you're concerned about falling short of your goal.

It's usually better to save more for retirement early and use compound interest to grow your savings than to rely on catch-up contributions to fund your retirement.

How Much Can I Deduct on My Taxes?

The amount you contribute to a traditional IRA is not always fully deductible. Restrictions on what you can deduct are based on income limits and your participation in a retirement plan at work. Once you reach these limits, the deduction begins to phase out, reducing the amount you can deduct on your taxes.

You can deduct your full traditional IRA contribution if you are:

  • Not covered by a retirement plan at work (or if you are married filing jointly, neither you nor your spouse is covered by a plan at work)
  • Covered by a plan at work and are filing singly or as head of household with a modified adjusted gross income is $66,000 or less in 2021 ($65,000 or less in 2020)
  • Covered by a plan at work and are married filing jointly with a MAGI of $105,000 or less in 2021 ($104,000 or less in 2020)

If you're married filing jointly and you are not covered by a plan at work but your spouse is, you can take:

  • The full deduction if your combined MAGI is $198,000 or less in 2021 ($196,000 or less in 2020)
  • A partial deduction if your combined MAGI is more than $198,000 but less than $208,000 in 2021 (more than $196,000 but less than $206,000 in 2020)
  • No deduction if your combined MAGI is more than $208,000 in 2021 (more than $206,000 in 2020)

You can take a partial deduction if you are covered by a retirement plan at work and you are:

  • Married filing separately and your MAGI is less than $10,000 in 2020 and 2021
  • Filing singly or as head of household with a MAGI is more than $66,000 but less than $76,000 in 2021 (more than $65,000 but less than $75,000 in 2020)
  • Married filing jointly with a MAGI that is more than $105,000 but less than $125,000 in 2021 (more than $104,000 but less than $124,000 in 2020)

You cannot take any deduction for contributions to a traditional IRA if you are covered by a retirement plan at work and you are:

  • Filing singly or as head of household with a MAGI of $76,000 or more in 2021 ($75,000 or more in 2020)
  • Married filing jointly with a MAGI of $125,000 or more in 2021 ($124,000 or more in 2020)

Contributions to a traditional IRA also make you eligible for the Saver's Credit on your taxes if you are:

  • At least age 18
  • Not claimed as someone else's dependent
  • Not a full-time student

What Are the Penalties?

You can withdraw money from your traditional IRA at any time. However, depending on when you do, you may be subject to penalties.

You can be penalized for:

Even if you don't yet need the money, you must begin taking distributions from a traditional IRA either:

  • By April 1 following the year you turn 72 (and by December 31 for subsequent years); or
  • By April 1 following the year you turn or 70 1/2 if you reached that age before January 1, 2020.

At that point, if you don't take at least the RMD each year, you'll face a 50% penalty of the RMD amount that you didn't take.

Early withdrawals are those made prior to turning age 59 1/2. These are subject to a 10% early withdrawal penalty. 

There are some exceptions for avoiding the penalty. You won't pay the penalty if:

  • You withdraw $10,000 to buy a first home.
  • The participant/owner of the plan has died.
  • The participant/owner of the plan is totally and permanently disabled.
  • You use the withdrawal to pay for qualified higher education expenses.
  • You use the withdrawal to pay for qualified unreimbursed medical expenses.
  • You use the withdrawal to pay for health insurance premiums while you are unemployed.
  • You are a qualified military reservist called to active duty.

However, you will still owe regular income tax on the withdrawal.

Do I Need a Traditional IRA?

A traditional IRA is a good option for saving pre-tax money for retirement if:

  • Your employer doesn’t offer a retirement plan.
  • You want to save even more for retirement after maxing out your 401(k).

However, if your income prevents you from deducting your contributions, you may be better off choosing an alternative investment strategy for your retirement.

Alternatives to a Traditional IRA

A Roth IRA is a popular alternative to a traditional IRA. This is also a tax-advantaged retirement account, but the tax benefits work a little differently:

  • There is no tax deduction for contributions.
  • Qualified withdrawals in retirement are tax-free.

You could gain more tax advantages from a Roth IRA if you anticipate being in a higher tax bracket once you retire or if your current income level prevents you from deducting contributions to a traditional IRA.

Another benefit of a Roth is that you don't have to take required minimum distributions at your RMD starting age. This allows your money to continue growing until you actually need it. You can also continue making new contributions as long as you have earned income for the year.

Key Takeaways

  • A traditional IRA is an investment account that offers tax-advantaged retirement savings.
  • Contributions to a traditional IRA are tax-deductible, though you must pay tax on withdrawals in retirement.
  • Restrictions on what you can deduct are based on income limits.
  • You must pay penalties you fail to take distributions from your IRA at your RMD starting age or if you take withdrawals from your account before age 59 1/2 (with some exceptions).
  • A Roth IRA is an alternative to a traditional IRA.