A traditional IRA is one of the most common ways for people to start working on their retirement plan. Overall, it allows people to make contributions without paying income tax at first.
People open a traditional IRA outside of their employer-sponsored retirement plan. Depending on your case, your tax deduction will be calculated depending on what your IRA contributions were.
There are many benefits of a traditional IRA besides your existing retirement plan at work, and this article aims to explain all of that process.
If you’re someone who wants to make long-term investments to secure your financial future, then traditional IRAs may be the right ones for you.
The following page will outline what a traditional IRA is, everything about its tax deduction requirements, the required minimum distributions, and more.
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What Is a Traditional IRA Account? Understanding the Individual Retirement Account
“What is considered a traditional IRA?” This is the most common question people make when they hear about any kind of IRA (self-directed IRA, Roth IRA, etc.)
The traditional IRA definition, overall, refers to an account where you will be able to make pre-tax contributions. In other words, your IRA contributions won’t be considered taxable income at the time you make them.
You can contribute to a traditional IRA without any problems until you start making withdrawals; there, you will pay taxes as usual.
Traditional IRA contributions can save you thousands of dollars in tax deductions as long as you’re eligible for this account.
Can You Make IRA Contributions?
It depends on the case. In the case of a traditional IRA, you can contribute if you have taxable compensation. If you’re filing jointly with your spouse, you can make traditional IRA contributions too.
On the other hand, we have a Roth IRA, where you contribute after-tax money, so any contributions grow tax-free.
With a Roth IRA, you can contribute at any age as you have taxable compensation and if your modified adjusted gross income is below particular amounts.
How Much Can You Contribute?
As of 2023, people can contribute less than $6,500 to their traditional or Roth IRA. On the other hand, if you’re 50 years old (or older), you may contribute up to $7,500.
You can also contribute your taxable compensation for the year. In any case, your deadline to contribute to a traditional IRA will be the same as your tax return filing deadline.
How Do Required Minimum Distributions Work?
In the case of a traditional IRA, you must start taking distributions before April 1st in the year after you turn 72 (or 70 and 1/2 if you reached that age before January 1st, 2020, and by December 31st of the following years).
How Does a Traditional IRA Work?
There are many factors that affect how a traditional IRA works that make it different than a regular retirement plan at work.
Here’s a list of everything you should know about an IRA traditional account:
- You will open your traditional IRA at a bank, Robo-advisor, or brokerage.
- A traditional IRA example for contributions includes stocks, bonds, and other similar assets. People who want long-term results tend to invest in stocks and bonds.
- People can add funds to their IRA through a rollover from their retirement plan at work or any other retirement account.
- You won’t have to pay income taxes until you withdraw your contributions. Moreover, you will have to pay a penalty if you make early withdrawals (we’ll expand on this later).
- A traditional IRA isn’t the same as a Roth IRA. We’ll explain the difference later in this article.
- You can deduct traditional IRA contributions if you don’t have a retirement plan at work. On the contrary, if you have one, your deductions may be limited.
A traditional IRA isn’t that complicated to understand, but you still should seek help from a reputable financial advisor if you want to make the most out of any type of individual retirement account you get.
What Are the Benefits of a Traditional IRA?
Why would you contribute to a traditional IRA? There are many reasons! Let’s go through each of them.
They’re Easy to Set Up
Generally speaking, most people should be able to open and contribute to a traditional IRA. All you need is to earn taxable income.
Moreover, there are no age limits for contributions, although the amount you can pay may depend on your current tax filing status and your modified adjusted gross income.
There are many banks and brokers you can use to open an IRA and enhance your retirement plan.
Finally, if you don’t want to handle your traditional or Roth IRAs yourself, you can hire a financial advisor to help you.
You Don’t Have to Pay Taxes When Contributing
The primary advantage of a traditional IRA is that you can grow tax-deferred earnings. If you believe you’ll be in a low tax bracket in the future, this tax-deferred growth will greatly help you.
When you start taking distributions, at age 72, you will pay regular income tax. In a sense, it may look like you’re investing more upfront than with a regular brokerage account, but keep in mind that you will also be able to withdraw more money when you retire.
Additionally, if you contribute up to $6,500 or $7,500 (depending on your age) in deductible contributions, you will be able to get a tax deduction, therefore, allowing you to reduce your income tax.
You Can Manage Your IRA Yourself
A disadvantage of a regular retirement plan like a 401(k) is that your employer can either change your plans or limit your investment options whenever they feel like it; this is because they’re the true owner of the account.
If you ever lose or leave your job, you won’t be able to contribute to that 401(k) retirement plan anymore, which translates to many financial problems for you and your family.
However, an IRA is 100% yours, and you won’t lose access even if you switch jobs. You can also roll over your old 401(k) funds into your traditional IRA, which gives you many more investment options to put your money to work.
There Are Many Options Available
While a traditional IRA is good enough for most people, some also go for Roth IRAs, which are recommended for younger people.
If you’re looking for more flexibility, then a Roth IRA could be a better option than a traditional one.
Is a Traditional IRA the Same as a Roth IRA?
Let’s dive deeper into the difference between Roth and traditional accounts:
- In a traditional IRA, you can contribute pre-tax dollars. On the contrary, a Roth IRA allows you to contribute after-tax dollars. This means that the latter option allows you to contribute with money you’ve already paid taxes on.
- You can have a tax deduction for certain contributions with your traditional IRA, but you can’t do the same with a Roth IRA.
- With a traditional IRA, you can remove your initial contributions, although that could warrant a penalty and more income taxes. Roth IRAs don’t give you any penalties.
- Finally, a traditional IRA will ask for minimum distributions, whereas a Roth IRA will not.
Are IRA Earnings/Gains Considered Taxable Income?
A popular question surrounding an IRA is: “Is a traditional IRA tax-deferred?” While we already covered how traditional IRA distributions and contributions work, let’s explain a bit further:
In essence, the earnings on a traditional IRA are tax-deferred. You can grow tax-deferred money without any problems to secure your financial future.
This is because a traditional IRA account is not taxable until you make a withdrawal at 59 and 1/2 years old. If you’re under that age, you might pay a 10% tax penalty (unless you’re eligible for an exception).
To summarize, you will have to pay regular income tax when you make a withdrawal and not a day before.
Keep in mind you must take RMDs as soon as you turn 72. These are mandatory withdrawals everyone must make so that they pay income tax eventually.
An individual’s RMD is calculated based on their life expectancy, which is calculated by IRS actuaries. Considering RMDs are taxed as regular income, you should plan ahead for when those days come.
In Roth IRAs, things are a bit different, as you will be contributing after-tax money. If you’re looking for tax-free growth or tax-free withdrawals, this may be a better option.
Are Contributions Made to an IRA Eligible for a Tax Deduction?
Your eligibility for a deduction will depend on three different factors:
- Your current income
- Your tax filing status
- Whether you’re covered by another retirement plan or not
When Will You Pay Income Tax for Your IRA?
You can make a withdrawal at any moment you want, and you will only pay income tax at that moment.
However, remember you may have to pay up to 10% in penalties and extra taxes if you make withdrawals before you reach the age of 59 and 1/2.
How Do You Open a Traditional IRA Account?
Now that you know everything about traditional IRAs and their tax-deferred growth potential for your money, let’s address how you can open one.
We briefly mentioned how to open traditional IRAs above, but we’ll dive deeper into that in this section:
Choosing Where to Open Your Traditional IRA
First, you must decide which institution you’ll use to open your traditional IRAs. Most people decide between an online broker and a robo-advisor. Which one is better?
If you want to be the one who manages all your investments, then an online broker is the way to go. In this case, you should look for a broker with low or zero account fees.
Good brokers will provide you with many different investment options, educational resources, and a high-quality customer support team.
On the other hand, if you want an automated, worry-free way to manage your investments, a robo-advisor may be a better option. In this case, you should look for an advisor with low management fees and a wide range of services.
Most robo-advisors offer portfolio allocation and automatic rebalancing features, which is standard. However, some other options also offer extra options like access to human advisors.
Opening Your Account
The steps to open traditional IRAs will depend on your broker or robo-advisor, but the process stays simple most of the time.
Typically, the process to open your account will go like this:
- Go to the provider’s website.
- Choose the IRA you’re interested in (traditional/Roth)
- Fill in the registration form with the necessary details.
That’s it! You will then be ready to start funding your account without any problems.
Funding Your Account
Now, you must address the way in which you’ll fund your account, as there are many methods, such as:
- Transferring your funds from a bank account
- Transferring IRA assets from a different firm
- Doing a rollover
If you’re doing a rollover from a 401(k), for example, you’ll have to contact the administrator of your former employee plan, fill out some forms, and wait until you get your new balance in your IRA.
On the other hand, if you’re funding from another bank or brokerage firm, you will need your account number/routing number to get started and then follow the instructions your provider gives you.
Keep in mind that those people who go for a robo-advisor don’t need to choose their investments, as the platform will take their financial preferences and goals and will use that to find the right investments.
IRAs may seem overwhelming at first, but they’re not so hard to understand. As long as you seek help from online resources or hire a financial advisor, you will be able to enjoy all the benefits that this account has to offer.
To summarize everything, opening a traditional IRA will help you with the following investment types:
- Save money for retirement with pre-tax contributions
- Cut your tax bill upon withdrawal
- Choose from a wide variety of investment assets like mutual funds and stocks
If you’re eager to open an IRA and start saving for retirement, make sure to go over the tips we just mentioned on this page!