What Is A Traditional IRA?

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what is a traditional ira
The Traditional IRA has been around since 1975. IRA stands for Individual Retirement Arrangement, but nearly everyone calls them Individual Retirement Accounts, which is perfectly fine. Traditional IRA’s were created by the government to encourage you and me to save more money toward our retirement years. One of the big things you should know about an IRA is that it is NOT an investment. It’s a special type of account where you keep all of your retirement investments such as stocks, bonds, real estate, CD’s, gold, etc.

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Look at it this way. Your bank account holds your cash and your IRA holds your investments.

Beyond that, Traditional IRA accounts have rules that make them much more unique than any bank account. Because some of the rules can get a little confusing, I’ll break them down into the major categories of Eligibility, Contributions, Investments, Tax Deductions, and Withdrawals.

Eligibility

Nearly everyone is eligible to create or open a Traditional IRA account. There are only two limitations, which are:

  • You have to be younger than 70 ½ years old.
  • You (or your spouse, if you are filing a joint return) must have taxable income this year.

Traditional IRA Contribution Limits

You can open a Traditional IRA account at a bank, credit union, brokerage firm, or other financial institution. All you have to do is fill out some paper work, deposit money, and start investing.

Of course, there is a limit on the amount of money that you can contribute to your IRA account each year.  For example, the maximum for 2013 is $5,500 (if you’re under age 50) and $6,500 (if you’re age 50 or older). These amounts tend to increase by about $500 every year.

IRA Investing

Investing the money that’s in your IRA is fairly straightforward. The place where you open your account will likely have a big menu of investment choices. They’ll help to fulfill your order and give advice, if you need it. Every month, you’ll get a statement from the financial institution and it will show you how well your investments are performing and the total balance.

Now remember earlier when I said that a Traditional IRA could be a good choice regardless of whatever other investments you have? That’s because the profits or earnings you make on your Traditional IRA investments will be allowed to grow tax-free in your account until you start withdrawing that money.

But be prepared to leave the money untouched in the IRA until you reach age 59.5. Otherwise, any withdrawals before that time will come with a severe tax penalty (unless you meet one of the hardship requirements).

The important point here is that having investments grow for many years without being taxed is a huge benefit

So there’s no doubt that opening a Traditional IRA is a no-brainer if your company doesn’t offer a retirement plan. Next, it’s a smart choice if you’ve first maxed out the contribution amount to your company’s retirement plan, and want a way to defer more taxes until later in life.

It’s also a no-brainer if you make too much money (six figures) to qualify for a Roth IRA.

Finally, there’s the question of what to do if you qualify for both the Traditional and Roth IRA. Which should you contribute to? Good questions.

If you didn’t already know, there is no problem with contributing to a Traditional and Roth IRA at the same time.  But you can’t exceed that annual contribution amount that I mentioned earlier. You’ll have to split it up.

As I also mentioned, I have both in my portfolio. Nowadays, I tell my family and friends to contribute to the Roth because you’ll never ever pay taxes on any of the profits your investments generate.  This is different from the Traditional IRA where you’ll eventually pay taxes on everything.  I discuss more of their differences shortly.

But don’t fret about the decision. Even if you decide to divide the contribution down the middle, you’ll be doing the right thing which is to continue to grow your portfolio.

IRA Tax Deductions

When something is tax deductible, it means that you can subtract it from your taxable income for that year, For a Traditional IRA, the issue is whether or not you can deduct your IRA contributions on your tax returns. This can get a little tricky.

That’s because it will depend on a couple of factors. The first factor is your income. The second factor is whether or not your employer offers a retirement plan such as a 401k. And it doesn’t matter if you actually participate in the plan or not.

If you’re not sure whether you’re covered by an employer retirement plan, you can ask your Human Resources department or pull out your W-2 form and look for a box labeled as “Retirement plan”. If it’s checked, you’re covered.

Once you know the answers to the two factors, then you will be eligible for either a full, partial, or no tax deduction. See, I told you it can get tricky. Here’s  the contribution deduction schedule if you are covered by an employer retirement plan:

Tax Filing Status

2013 Income

Tax Deduction Level

Single or Head of Household Less than $59,000 Full
Single or Head of Household $59K to $69K Partial
Single or Head of Household Over $69,000 None
     
Married (Filing Jointly) Less than $95,000 Full
Married (Filing Jointly) $95K to $115K Partial
Married (Filing Jointly) Over $115K None
     
Married (Filing Separately) Lass then $10,000 Partial
Married (Filing Separately) Over $10,000 None

 

To determine the partial deduction amount for your specific income, just perform an online search for an IRA Deduction Calculator https://scs.fidelity.com/products/mobile/ira/ira-calc.shtml . The calculator will ask you for your Modified Adjusted Gross Income (MAGI). This is basically your income re-adjusted for certain deductions that you’re taking on your tax return. To keep things simple, just enter your annual income as you know it to be. It’s only important if your income is bumping against one of the upper or lower limits.

Next, if your Employer DOES NOT Offer a Retirement Plan, you get a full tax deduction regardless of income as long as your spouse’s employer does not offer a retirement plan.

Finally, here’s the deduction schedule if your employer doesn’t offer a retirement plan, but your spouse’s employer does.

Tax Filing Status

2013 Income

Tax Deduction Level

Married (Filing Jointly) Less than $178,000 Full
Married (Filing Jointly) $178K to $188K Partial
Married (Filing Jointly) Over $188K None
     
Married (Filing Separately) Lass then $10,000 Partial
Married (Filing Separately) Over $10,000 None

 

Withdrawals

When you place money in your Traditional IRA, you should do so with the expectation that you won’t touch it until age 59.5 or later.  That’s because if you make any early withdrawals before that age, it’s going to cost you. Expect to pay an additional 10% penalty on the money you withdraw in addition to regular income tax rates.

Now, there is a very limited amount of flexibility for withdrawing money without penalty. In most cases, it has to be some sort of hardship. Examples include medical issues, education, and being a first-time home buyer.

Next, you are NOT required to withdraw money from your Traditional IRA at age 59.5. Leave it in a while longer, if you like. However, you MUST begin to make withdrawals beginning at age 70.5. You’ll then have to pay taxes on the distributed amounts.

So at that age, the IRS rules require that you withdraw a minimum amount of the total in the account.   They actually call it a “Required Minimum Distribution” calculation. There’s a formula for it. If you perform and online search for IRS Publication 590, it will lead you the rules for “Required Minimum Distributions” and a table that will help you to determine the distribution percentage.

Traditional IRA Versus Roth IRA Revisited

The big difference between a Traditional IRA and a Roth IRA is the timing for when you’ll pay income taxes on the money in the accounts.  For a Traditional IRA, the taxes are paid at the “back end”. This means you will pay them at the time the money is withdrawn later in your life.  Also, as we just covered in the prior section, your contributions may or may not be tax deductible.

On the other hand, a Roth IRA functions under the exact opposite tax scenario.  The money you contribute to your Roth is taxed upfront, in your paycheck. But, you won’t pay any more taxes on any of the funds (including investment profits) when they are withdrawn from the account after you reach age 59.5. Unfortunately, you cannot deduct contributions on your income tax returns.

For both IRAs, the money is allowed to grow tax-free, provided that it remains within the account.

Another difference between Traditional and Roth IRAs is related to eligibility and income limits. This means that nearly everyone can open and contribute to a Traditional IRA, regardless of income. But, you will not be able to make contributions to a Roth IRA if your income is above a certain amount,

Finally, Roth IRAs provide greater flexibility. For example, you can withdraw your personal contributions any time without incurring a tax penalty. Likewise, you can leave money in your Roth account for as long as you want, allowing the funds to continue to grow until (and even after) you die.

However, you can’t do this with a Traditional IRA. For it, you absolutely MUST begin to withdraw money from the account and pay taxes on it by the age of 70 ½ years old.

Action Step:

  • Establish and contribute to a Traditional IRA if your company doesn’t offer a retirement plan, you don’t qualify for a Roth IRA, or you’ve maxed out your company retirement plan contributions and want another way to have investment profits grow tax-free for many years.

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