“What is a Traditional IRA?” This is a question asked by those who want to set up a retirement savings account (IRA). Having a deeper understanding of an IRA, especially the Traditional IRA rules, can help you decide if this is the right type of IRA for you.
What Is a Traditional IRA? | Rules, Limits, and Benefits
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What Is a Traditional IRA?
What is a Traditional IRA according to the Internal Revenue Service (IRS)? The agency describes it as a tax-deferred retirement savings account. This means the government does not tax your contributions. The tax applies when you make a withdrawal.
The investments you make into your account come from your pre-tax income. This is beneficial if you want to save more money initially.
Does This Mean You Do Not Pay Taxes on a Traditional IRA?
The term “tax-deferred” can be confusing. To explain, it means the government postpones or delays the imposition of the tax.
For example, the rule says you pay taxes on your withdrawals, which you can do anytime. It is explicit, though, you have to make a mandatory withdrawal (or distribution) once you reach the Traditional IRA withdrawal age, 70.5 years old.
Another age to remember is 59.5 years old. The rules allow you to withdraw money before you reach this age. The downside is that you pay a 10 percent penalty on top of the ordinary income tax for withdrawing your money before you reach 70.5.
You can use a Traditional IRA early withdrawal calculator to give you a better idea of the approximate costs associated with different withdrawal ages.
Traditional IRA vs Roth IRA
There are different types of IRAs. Two of the most popular are Traditional IRA and Roth IRA.
One of the biggest differences between the two is the treatment of the contribution. With a Traditional IRA, your savings come from pre-tax money. The government, thus, allows you to use it to reduce your taxable income. How much you can deduct depends on Traditional IRA income limits.
With a Roth IRA, your savings are from post-tax income. You cannot use your contributions to reduce your taxable income. The benefit here is that your savings, earnings, and withdrawals are tax-free.
These IRA types also share similarities. The Traditional IRA contribution limits are the same as those of a Roth IRA.
Each tax year, you can contribute only $5,500 to your IRA. If you are 50 or older, you can add $1,000 as a catch-up contribution. A Traditional IRA has an age limit of 70.5 years old. This means you cannot contribute after this age.
If you have both accounts, the sum of your contributions each tax year should not exceed the limits.
What Are the Advantages of a Traditional IRA?
Here are some of the benefits of choosing a Traditional IRA:
- Anyone with an income can contribute to Traditional IRA.
- You can claim your contributions as deductions if you do not itemize. You can use a Traditional IRA eligibility calculator to know how much you can deduct.
- In some cases, you can withdraw funds from your Traditional IRA without paying the penalty. An example is to use Traditional IRA for college tuition. (You still have to pay taxes on the distribution amount, though.) You can also withdraw up to $10,000 from an IRA to put towards the down payment on a home.
Some Important Things You Should Know about a Traditional IRA
- It builds up your savings while lowering your yearly taxes. If you open a Traditional IRA at age 25 and put the maximum contribution in it each year, you could have almost one million dollars saved by the time you reach 65, assuming you have a decent interest rate.
- When you are over 50, you get to contribute an extra $1,000 dollars a year.
- You can also contribute to an IRA for a nonworking spouse, so you can make twice the contributions each year.
- Contribution deadlines extend into the next year. If you do not contribute the full amount this year, you can still add to it up until April 15 the following year.
- You can have a 401(k) and a Traditional IRA at the same time. Maxing out the contributions to both may affect your tax benefits for the IRA, though.
- You should name the beneficiaries for your Traditional IRA account. Life does not always go the way you plan, so be prepared. Usually, beneficiaries do not have to worry about the early withdrawal penalty. Spouses just need to remain beneficiaries and avoid transferring the IRA to their name.
- Banks offer IRAs as do brokerage firms. Look closely at any fees they charge, though. Most are low to no cost, so make sure you are getting a good deal.
Hopefully, all these details help answer the question, “What is a Traditional IRA?” In summary, a Traditional IRA is an excellent way to begin saving and building your nest egg for retirement. Be patient, and your investment will work for you, so you don’t have to.
Do you have a Traditional IRA? How do you intend to use your savings? Share with us your experience and thoughts in the comments section below.