Traditional IRA

What is a Traditional IRA?

Louis DeNicola

A traditional individual retirement arrangement — often referred to as an individual retirement account or IRA — is a type of tax-advantaged account. Unlike an employer-sponsored retirement account, such as a 401(k), you open and contribute to an IRA on your own rather than through work.

With traditional retirement accounts, your contributions may be tax deductible, and your savings can grow tax-free. There are also Roth retirement accounts, which offer other tax benefits, but don’t lead to tax deductions.

what is a traditional ira

If saving for retirement is one of your financial priorities, a traditional IRA can be a good option. But first, learn about its limitations and how traditional IRAs compare to other types of retirement accounts.

How Does a Traditional IRA Work?

You can open traditional IRA accounts at many financial institutions. Once your account is open, you add money to it and choose how you want to save or invest the funds.

Generally, people invest the money in their IRA in stocks, bonds, mutual funds, and exchange-traded funds (ETFs). If you don’t want to take on a lot of risk, you could also open an IRA at a bank and put the money into a high-yield savings account or certificate of deposit (CD).

Traditional IRAs offer two primary tax benefits:

  • You may get a tax deduction for the money you contribute to the IRA.
  • You don’t pay taxes on any earnings until you withdraw the money later.

Sometimes traditional IRA contributions are called pre-tax money because you’re using funds that haven’t been taxed yet. The tax benefits mean you may be able to invest more today and earn more than you would with a standard brokerage account — which requires you to pay taxes on earnings annually.

how does an ira work

You’ll have to include your traditional IRA withdrawals in your taxable income later. However, many people have less income and are in lower tax brackets during their retirement years.

How Much Can I Contribute to a Traditional IRA?

Considering the tax benefits, some people may want to invest as much as possible in their IRA. However, the Internal Revenue Service (IRS) limits your contributions to an IRA each year.

  • In 2019, 2020 and 2021, the annual contribution limit is the lesser of $6,000 or your taxable compensation (e.g., wages and self-employment income) for the year. The limit on traditional IRA contributions tends to increase every few years.
  • If you’re 50 or older, the potential annual limit increases to $7,000.
  • If you’re married and file jointly, you can both contribute to a traditional IRA even if one person doesn’t have taxable compensation. However, you must have separate IRAs, and your combined gross income may limit your contribution amounts.
  • Before 2020, you couldn’t contribute to an IRA once you turned 70½, but there’s no longer an age limit.

You can open and have multiple IRAs, including non-traditional Roth IRAs. However, all traditional IRA and Roth IRA contributions count toward your limit for the year. We’ll cover more about the Roth IRA below.

If you contribute more to your traditional IRA than you’re allowed to, you may have to pay a 6% penalty each year that the money stays in your account. You can avoid the penalty by withdrawing the excess and associated earnings before your tax filing deadline — usually April 15. It could be October 15 if you receive an extension.

Are Contributions to a Traditional IRA Tax Deductible?

If you — and your spouse, if you’re married — don’t have a retirement account from an employer, then your entire traditional IRA contribution is tax deductible. However, your deductible contributions may be limited if you or your spouse contributed to an employer’s plan, such as a 401(k), stock bonus, profit-sharing or pension plan.

You can still contribute the full amount. But whether you receive a full, partial or no deduction depends on your modified adjusted gross income (MAGI) and tax filing status.

The IRS has two charts you can review to see the income limits. One for taxpayers who are covered by a retirement plan at work. And another for taxpayers who aren’t covered or whose spouse is covered by a retirement plan at work.

Traditional IRA Benefits and Drawbacks

The benefits of an IRA make it an appealing way to save for retirement. However, in some situations, you might want to start with other retirement accounts.



Pros



Cons



There’s no maximum income limit or age limit for making traditional IRA contributions.



The IRS sets annual contribution limits for IRAs.



Traditional IRA contribution deductions aren’t itemized deductions.



Your deduction could be limited if you contribute to a retirement plan at work and your MAGI is too high.



There are a few exceptions that allow you to make early withdrawals without a penalty, such as paying for educational expenses.



Withdrawing money before you’re 59½ years old could lead to a 10% early distribution penalty.



You don’t pay taxes on your investments while they grow.



You may have to start taking required minimum distributions (RMDs) once you turn 72.

Other Things to Know About Traditional IRAs

There are lots of rules to be aware of when opening or using a traditional IRA. Here are a few more things you’ll want to keep in mind.

The Contribution Deadline for 2022 is April 15

The traditional IRA contribution deadline for the year is the tax deadline during the following year. For example, you can contribute to a traditional IRA for the 2021 tax year until April 15, 2022. When you make a contribution, you can select which tax year you want the contribution to count toward. Your annual contribution limit is based on the tax year you select, regardless of when you transfer the funds.

You Can Have an IRA in Addition to a 401(k)

You can contribute to a 401(k) through work and one or more IRAs at the same time. And, your contribution limits for your 401(k) and IRAs are completely separate. However, if you or your spouse contribute to an employer plan, your IRA deduction may be limited for the year based on your tax filing status and income.

You Can Make Early Withdrawals from a Traditional IRA

You usually have to pay a 10% if you take traditional IRA withdrawals before you turn 59½. However, there are a few exceptions that allow you to take penalty-free traditional IRA early withdrawals. For example, there’s no penalty to take up to $10,000 for first-time homebuyers, to pay for health insurance premiums while you’re unemployed or to pay for qualified higher education expenses. The IRS has a chart with the full list of exceptions.

If Your Spouse is Non-Working, They Get Their Own IRA

You normally have to have taxable compensation during the year to contribute to a traditional IRA. However, if you’re married and file taxes jointly, the non-working spouse can open and contribute to their own IRA based on the couple’s income.

You Must Take Your Required Minimum Withdrawals

You must take required minimum withdrawals (RMDs) from your account once you reach a certain age. The RMDs are a potential negative, as you might not want to withdraw the money if you’re in a high tax bracket that year. Starting in 2020, the traditional IRA withdrawal age increased from 70½ to 72. Now, you have to start taking RMDs by April 1 of the year after you turn 72.

Alternative to a Traditional IRA

A traditional IRA can be a great investment tool, especially if you don’t have access or already maxed out your employer-sponsored retirement plan contributions. However, it’s not necessarily the best option for everyone.

For example, if your employer matches part of your 401(k) contributions, you may want to focus on getting the full match before contributing to an IRA. There are also Roth IRAs and Roth 401(k)s. With Roth accounts, you don’t receive a tax deduction today, but all your contributions and earnings can be withdrawn tax-free later.

There are other differences between traditional and Roth IRAs to consider as well, such as income limitations on contributions and withdrawal requirements. But, in general, traditional accounts are better if you’re in a high tax bracket today. And Roth accounts could be best if you think you’ll be in a higher tax bracket during retirement.

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