What Is a Traditional IRA?

What Is a Traditional IRA?

A traditional individual retirement account (IRA) allows individuals to direct pre-tax income toward investments that can grow tax-deferred. The IRS assesses no capital gains or dividend income taxes until the beneficiary makes a withdrawal. Individual taxpayers can contribute 100% of any earned compensation up to a specified maximum dollar amount.

Income thresholds may also apply. Contributions to a traditional IRA may be tax-deductible depending on the taxpayer's income, tax-filing status, and other factors. Retirement savers may open a traditional IRA through their broker (including online brokers or robo-advisors) or financial advisor.

Key Takeaways

  • Traditional IRAs (individual retirement accounts) allow individuals to contribute pre-tax dollars to a retirement account where investments grow tax-deferred until withdrawal during retirement.
  • Upon retirement, withdrawals are taxed at the IRA owner's current income tax rate. Capital gains or taxes on dividends are not assessed.
  • Contribution limits exist ($6,000 for 2021 and 2022 for those under age 50, $7,000 for those 50 and older), and required minimum distributions (RMDs) must begin at age 72.
  • Unqualified withdrawals from a traditional IRA prior to the age of 59.5 years old are subject to income tax in addition to a 10% penalty.
  • Unlike Roth IRA contributions, traditional IRA contributions are deductible from your current taxable income.
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How Traditional IRAs Work

How Traditional IRAs Work

Traditional IRAs let individuals contribute pre-tax dollars to a retirement investment account, which can grow tax-deferred until retirement withdrawals occur (at age 59½ or later). Custodians, including commercial banks and retail brokers, hold traditional IRAs and place the invested funds into different investment vehicles according to the account holder’s instruction and based on the offerings available.

In most cases, contributions to traditional IRAs are tax-deductible. If someone contributes $6,000 to their IRA, for example, they can claim that amount as a deduction on their income tax return and the Internal Revenue Service (IRS) will not apply income tax to those earnings. However, when that individual withdraws money from the account during retirement, earnings are taxed at their ordinary income tax rate.

The IRS restricts the amount that one may add to a traditional IRA each year, depending on age. The contribution limit for the 2021 and 2022 tax year is $6,000 for savers under 50 years of age. For people aged 50 and above, higher annual contribution limits apply via a catch-up contribution provision, allowing for an additional $1,000 (or a total of $7,000) per year.

Under the SECURE Act, passed at the end of 2019, age restrictions on contributions to a traditional IRA were lifted. As long as the account holder has earned income to qualify, they are eligible to contribute to a traditional IRA regardless of age.

$6,000

The maximum amount an individual under age 50 can contribute to a traditional IRA for the tax year 2022 (unchanged from 2021).

Traditional IRAs and 401(k)s or Other Employer Plans

When you have both a traditional IRA and an employer-sponsored retirement plan, the IRS may limit the amount of your traditional IRA contributions that you can deduct from your taxes.

If a taxpayer participates in an employer-sponsored program such as a 401(k) or pension program and files as a single person, they would only be eligible to take the full deduction on a traditional IRA if their modified adjusted gross income (MAGI) was $66,000 or less for 2021 ($68,000 for 2022). Married taxpayers filing a joint return are subject to limits of $105,000 or less for 2021 ($109,000 for 2022).

With MAGIs of $76,000 for singles in 2021 ($78,000 for 2022) and $125,000 for married couples in 2021 ($129,000 for 2022), the IRS allows no deductions. The deduction is phased out should the filer's income fall between the the minimum and maximum levels above.

IRA contributions must also be made by the tax filing deadline. For most taxpayers, this is on or around April 15th of each year. If you are above the limits, you can still contribute post-tax income to a traditional IRA and take advantage of its tax-free growth, but investigate other options, too.

Income tax will ultimately have to be paid on IRA money at the time of withdrawal, subject to one's tax bracket during retirement. Therefore, traditional IRAs are more often recommended for investors who expect to be in lower tax brackets at retirement than they are currently in.

Traditional IRA Distributions

When you receive distributions from a traditional IRA, the IRS treats the money as ordinary income and subjects it to income tax. Account-holders can take distributions as early as age 59½. Starting after age 72, account holders must take required minimum distributions (RMDs) from their traditional IRAs.

Funds removed before full retirement eligibility incur a 10% penalty (of the amount withdrawn) and taxes, at standard income tax rates. There are exceptions to these penalties for certain situations. These include the following:

  • You plan to use the distribution towards the purchase or rebuilding of a first home for yourself or a qualified family member (limited to $10,000 per lifetime).
  • You become disabled before the distribution occurs.
  • Your beneficiary receives the assets after your death.
  • You use the assets for unreimbursed medical expenses.
  • Your distribution is part of a substantially equal periodic payment (SEPP) program.
  • You use the assets for higher-education expenses, or expenses incurred for having or adopting a child.
  • You use the assets to pay for medical insurance after you lose your job.
  • The assets are distributed as a result of an IRS levy.
  • The amount distributed is a return on non-deductible contributions.
  • You are in the military and called to active duty for more than 179 days.

It's important for an individual to check with a tax attorney or the IRS to be sure that the particulars of their situation qualify for a waiver of the 10% penalty.

Set by the SECURE Act, which became law in December 2019, the age 72-threshold applies from 2020 onwards. The old RMD threshold of 70½ still applies if you turned that age before Dec. 31, 2019.

Traditional IRAs vs. Other IRA Types

Other variations of the IRA include the Roth IRA, SIMPLE IRA, and SEP-IRA. The last two are employer-generated, but individuals can set up a Roth IRA if they meet the income limitations. These individual accounts can be created through a broker. You can check out some of the best options with Investopedia's list of the best brokers for IRAs.

Roth IRAs

Unlike a traditional IRA, Roth IRA contributions are not tax-deductible, and qualified distributions are tax-free. This means you contribute to a Roth IRA using after-tax dollars, but as the account grows, you do not face any taxes on investment gains. Because you paid taxes on your contributions, you can actually withdraw them, penalty-free, at any time. However, you cannot withdraw earnings until age 59½ without being subject to the 10% early-withdrawal penalty.

When you retire, you can withdraw from the account without incurring any income taxes on your withdrawals. Roth IRAs do not have RMDs. If you don't need the money, you don't have to take it out of your account and worry about penalties for failing to do so. You can also pass the money to your heirs if you don't end up needing to use it.

Roth IRA contributions for 2021 and 2022 are the same as for traditional IRAs: $6,000, unless you are 50 or older and can qualify for the catch-up contribution, which raises the limit to $7,000. The catch is that not everyone qualifies to contribute to a Roth IRA. There are income limitations, with contributions gradually phased out as your MAGI increases.

The income phase-out range for Roth contributions for married couples filing jointly is $198,000 to $208,000 for 2021 ($204,000 to $214,000 for 2022); for singles and heads of household, it's $125,000 to $140,000 for 2021 ($129,000 to $144,000 for 2022). If you earn above those amounts, you can't contribute to a Roth at all.

SIMPLE and SEP-IRAs

SIMPLE IRAs and SEP-IRAs are benefits instituted by an employer so individuals cannot open them, although self-employed or sole proprietors may. Generally, these IRAs function similarly to traditional IRAs, but they have higher contribution limits and may allow for company matching.

A simplified employee pension (SEP, or SEP-IRA) is a retirement plan that an employer or self-employed individual can establish. The employer is allowed a tax deduction for contributions made to the SEP plan and makes contributions to each eligible employee's SEP-IRA on a discretionary basis. Fundamentally, a SEP-IRA can be considered a traditional IRA with the ability to receive employer contributions. One major benefit it offers employees is those employer contributions are vested immediately.

A SIMPLE IRA is a retirement savings plan that can be used by most small businesses with 100 or fewer employees. "SIMPLE" stands for "Savings Incentive Match Plan for Employees." Employers can choose to make a 2% retirement account contribution to all employees or an optional matching contribution of up to 3%.

Employees can contribute a maximum of $13,500 annually in 2021 ($14,000 for 2022); the maximum is increased periodically to account for inflation. Retirement savers age 50 and older may make an additional catch-up contribution of $3,000, bringing their annual maximum to $16,500 in 2021 and $17,000 in 2022.

Opening a Traditional IRA

You can open a traditional IRA as long as you received taxable compensation during the year you want to contribute or your spouse earned taxable compensation and you will file a joint return. If both you and your spouse have compensation, both parties can open their own traditional IRA.

A variety of organizations, financial institutions, or brokerage firms can assist in setting up a personal traditional IRA. The account is subject to IRS code requirements, and the custodian of your account (often the brokerage firm you choose such as Fidelity or Vanguard) will manage the account requirements on your behalf.

Contributions into a traditional IRA can be made immediately through your account holder in the form of cash, check, or money order. Physical property is not an allowable contribution type. When setting up an account, there is no minimum balance or starting investment required.

What Is the Difference Between a Traditional IRA and Roth IRA?

The primary difference between a Traditional and Roth IRA is the tax treatment of each account. Traditional IRA contributions are deductible from taxable income when the contributions are made; however, earnings are taxable. Alternatively, Roth contributions are not deductible but can grow tax-free.

In addition, there are differences on the mechanisms of each IRA. Roth IRA contributions can be withdraw for no penalty, while Traditional IRAs can not. In addition, some Roth earnings may be able to be withdrawn for no penalties for specific uses (i.e. first time homebuying down payment).

What Are the Rules for a Traditional IRA?

There are several rules for a traditional IRA. The maximum contribution amount depends on your age, and the IRS requires individuals to begin taking money out of their traditional IRA at age 72. The traditional IRA is subject to income taxes and a 10% penalty if unqualified withdrawals occur before 59.5 years old. Last, your annual contribution into a traditional IRA can not exceed what you earned in the contribution year.

What Are the Different Types of IRAs?

The two most common types of IRAs are the traditional IRA and Roth IRA. Less popular types of IRAs include SEP IRAs (often best for self-employed or small business owners), SIMPLE IRA (often best for small companies that still have numerous employees), or self-directed IRAs (often used by experienced investors seeking specific alternative asset investments).

What Are the Disadvantages of Traditional IRAs?

Like other retirement savings vehicles, funds can often not be withdrawn without tax and fine penalties. Therefore, Traditional IRAs are very illiquid savings accounts. In addition, traditional IRAs do not grow tax-free; earnings withdrawn at retirement are subject to tax.

Does a Traditional IRA Grow Tax-Free?

No, a traditional IRA does not grow tax-free. Contributions into a traditional IRA receive favorable tax treatment and is often deducted from an employee's taxable income. When it is time to withdraw earnings, any growth on the investment is taxable. In the meantime, earnings are tax-deferred. This is opposite treatment of Roth IRAs where initial investments can not be deducted from income, but its growth can be withdrawn tax-free at retirement.

The Bottom Line

One of the more common vehicles used for saving for retirement is the traditional IRA. A traditional IRA allows for savers to contribute money into a tax-deferred vehicle using post-tax (deductible) contributions. Although this investment vehicle can't be accessed until retirement without taxes and penalties, taxes on the growth of your investment is deferred until retirement.

Article Sources
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