What Is a Traditional IRA?

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DEFINITION

A traditional IRA is an investment account that offers tax-advantaged retirement savings. Contributions to a traditional IRA may be tax-deductible, though you must pay tax on withdrawals in retirement.

Definition and Example of a Traditional IRA

A traditional IRA is an investment account used to save for retirement in addition to, or in place of, an employer-sponsored retirement account. You hold the account individually in your own name.

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

The money you've contributed to the account then grows tax-deferred. Interest or capital gains from the investments aren't taxed in the same way as when dividends are received in a taxable brokerage account. Taxation is instead postponed.

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

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.

Anyone age 70 1/2 or over was ineligible to contribute to a traditional IRA before 2020, even if they had earned income. This rule was eliminated on January 1, 2020.

You can open a traditional IRA through a brokerage, a mutual fund company, or even your local bank. 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 your values and how close you are to retirement.

Many financial institutions offer target-date retirement funds. These funds generally start out with more aggressive investing, giving you the potential to earn more when you're younger. You'll have time to recover from any potential setbacks. The balance of investments held in the account automatically becomes more conservative as you get closer to retirement.

The amount that you contribute each year can often be claimed as a deduction when you file your taxes.

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 to account for fluctuations in the market over time.

How to Contribute to a Traditional IRA

The maximum contribution you can make to all your IRAs, including both traditional and Roth accounts, is $6,000 in 2022, but you can contribute up to $7,000 if you're age 50 or older. This contribution limit does not apply to rollover contributions. You can't contribute more than your earned income if your total earned income for the year was less than the maximum contribution limit.

It's usually better to save more for retirement early. You can use compound returns to grow your assets rather than rely on catch-up contributions.

The higher amount for older savers is known as a "catch-up contribution" for those who are closer to retirement age. It allows you to gain ground in your retirement-saving efforts.

How Much Can I Deduct on My Taxes?

The amount you contribute to a traditional IRA isn't always fully deductible. Restrictions on what you can deduct are based on income limits and whether you or your spouse participate in a retirement plan at work. Once you reach these limits, the deduction begins to phase out, thus 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 (MAGI) of $68,000 or less in 2022 (up from $66,000 or less in 2021).
  • Covered by a plan at work and are married filing jointly with a MAGI of $109,000 or less in 2022 (up from $105,000 or less in 2021).

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

  • The full deduction if your combined MAGI is $204,000 or less in 2022 (up from $198,000 or less in 2021)
  • A partial deduction if your combined MAGI is more than $204,000 but less than $214,000 in 2022 (up from more than $198,000 but less than $208,000 in 2021)
  • No deduction if your combined MAGI is more than $214,000 (up from $208,000 in 2021)

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

  • Married filing separately, and your MAGI is less than $10,000 in 2022 and 2022
  • Filing singly or as head of household with a MAGI that is more than $68,000 and less than $78,000 in 2022 (up from more than $66,000 but less than $76,000 in 2021)
  • Married filing jointly with a MAGI that is more than $109,000 and less than $129,000 in 2022 (up from more than $105,000 but less than $125,000 in 2021)

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

  • Filing singly or as head of household with a MAGI of more than $78,000 (up from $76,000 or more in 2021)
  • Married filing jointly with a MAGI of more than $129,000 in 2022 (up from $125,000 or more in 2021)

Contributions to a traditional IRA can also make you eligible for the Saver's Tax Credit if you are at least age 18, you are not claimed as someone else's dependent, and you aren't a full-time student.

What Are the Penalties?

You can withdraw money from your traditional IRA at any time, but you may be subject to penalties, depending on when and why you do. You can be penalized for failing to take required minimum distributions (RMD) on time and for taking early withdrawals.

Required Minimum Distributions

You must begin taking distributions from a traditional IRA even if you don't yet need the money. You must do so by April 1 following the year you reach age 72 (and by December 31 for subsequent years), or by April 1 following the year you reach age 70 1/2 if you reached that age before January 1, 2020.

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

Early Withdrawals

Early withdrawals are those made prior to reaching age 59 1/2. They are subject to a 10% early-withdrawal penalty, but there are some exceptions. 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

You'll 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, or if you want to save even more for retirement after maxing out your 401(k). However, you may be better off choosing an alternative investment strategy for your retirement if your income prevents you from deducting your contributions.

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 bit differently. There's no tax deduction for contributions, but qualified withdrawals are tax-free in retirement.

You could gain more tax advantages from a Roth IRA if you anticipate being in a higher tax bracket when 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 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 may be tax-deductible, but you must pay tax on withdrawals in retirement.
  • Restrictions on what you can deduct are based on income limits.
  • You must pay penalties if 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.

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