What is a Traditional IRA?
Published on April 18, 2011
A traditional IRA (individual retirement account) is any IRA that is not a Roth IRA or a SIMPLE IRA. Click here to learn about Roth IRA versus traditional IRA.
You can set up and make contributions to a traditional IRA if you (or, if you file a joint return, your spouse) received taxable compensation during the year, and you were not age 70½ by the end of the year.
You can also have a traditional IRA whether or not you are covered by any other retirement plan. However, you may not be able to deduct all of your contributions if you or your spouse is covered by an employer retirement plan.
If both you and your spouse have compensation and are under age 70½, then each of you can set up an IRA but you cannot both participate in the same traditional IRA.
If you file a joint return, then only one of you needs to have compensation.
A traditional IRA is an account that is used to save pre-tax dollars for use in retirement. An IRA can be opened at a variety of places such as a brokerage, mutual fund company, or even at your local bank. The money in the account can generally be invested in stocks, bonds, mutual funds, or CDs, subject to the availability of products within your account.
WHAT IS THE TRADITIONAL IRA PRETAX ADVANTAGE?
The primary benefit of a traditional IRA is that in most cases, the contributions are made on a pre-tax basis. This means that when you deposit money into the traditional IRA, you can deduct that amount from your taxable income. This results in paying less income tax for the year.
In addition to receiving the tax deduction up front from your traditional IRA, the money in the traditional IRA account grows tax deferred. Any interest or gains from the traditional IRA investments are not taxed when the gains are realized. Instead, the gains from your traditional IRA are deferred until money is withdrawn from the IRA, at which point the money is taxed as ordinary income.
WHAT ARE TRADITIONAL IRA ELIGIBILITY REQUIREMENTS?
Anyone under age 70 ½ with earned income is eligible to open a traditional IRA, but there are some restrictions as to who can deduct the contributions. There are income limits that are used to determine how much of the contributions are deductible, if you or your spouse are participants in an employer plan.
WHAT ARE TRADITIONAL IRA DISTRIBUTION REQUIREMENTS?
One of the potential disadvantages of a traditional IRA is the forced distribution that must begin at age 70½. Even if you don’t need the money, if you do not take at least the required minimum distribution (RMD) each year, you are subject to stiff penalties. In addition, withdrawals made prior to turning age 59½ are subject to an early withdrawal penalty in addition to taxes owed.
IS A TRADITIONAL IRA RIGHT FOR YOU?
If your employer doesn’t offer a retirement plan, then a traditional IRA is generally a good option for saving pretax money for retirement. Keep in mind that, depending on whether you, or your spouse if you are married, are covered by a retirement plan at work, you may be subject to income limitations that affect the deductibility of your contribution to a traditional IRA.
For many people, once they reach retirement, they find themselves in a lower tax bracket than when they were employed. This means you receive a greater tax break on the contributions during your working years, and later in life when you are not working and withdraw this money, it is taxed at a lower rate. Unfortunately, it is impossible to predict what will happen to tax rates in the future, which is why it is important to have multiple sources of retirement savings. If we have not answered all your questions regarding “what is a traditional IRA,” please feel free to contact us. We’re here to help.