Traditional IRA Explained - What, Who, When, Where, & How
The Traditional IRA explained. This is a guide for the U.S. tax-deferred individual retirement account. Here we'll explore what a Traditional IRA is, who they're for, when to contribute, and where, why, and how to open one.
What Is a Traditional IRA?
A Traditional IRA is simply a U.S. retirement savings vehicle by which investors contribute pre-tax income, that money grows tax-deferred, and the withdrawals later in retirement are taxed as ordinary income.
The Traditional IRA was established in 1974 by the Employee Retirement Income Security Act. IRA stands for individual retirement account. As the name suggests, this is an account designed to help individuals save for retirement.
Who Can Contribute To a Traditional IRA?
Whereas an account like a 401k is tied to your employer, anyone with earned income below the can open a Traditional IRA on their own. Contributions may be tax-deductible depending on your income. We'll cover income limits later.
How Does a Traditional IRA Work?
The main function of the Traditional IRA is that contributions are made with pre-tax dollars (in most cases they are tax-deductible), those contributions are allowed to grow tax-deferred, and withdrawals later in retirement are taxed as ordinary income. In other words, contributions to a Traditional IRA are taxed on the back end and not on the front end.
Those contributions must be made in cash. There are limits imposed by the IRS for the amount of annual contributions that can be made to a Traditional IRA. We'll go over these contribution limits in a bit.
Traditional IRAs have what are called required minimum distributions, or RMDs. This means you have to start withdrawing after age 73 whether or not you actually need that money. This is because Uncle Sam wants to collect on his tax revenue that you've avoided up to that point.
Accountholders can start withdrawing without penalty at age 59.5. Withdrawals before that age will incur a 10% penalty plus taxes.
There are also special cases that allow for the early withdrawal of earnings without penalty, including:
First time home purchase; you can withdraw up to $10,000.
Higher education expenses
Medical expenses
Death
Disability
Substantially equal periodic payments
Consult your tax professional if any of those apply to you.
Also note that you can open a Traditional IRA in addition to an employer-sponsored plan (ESP) like a 401k. But having an ESP reduces the amount the IRS allows you to contribute to a Traditional IRA. If you leave an employer, you'll also usually have to roll over your 401k into a Traditional IRA.
Investments
You have a wide variety of things you can invest in inside a Traditional IRA, including mutual funds, ETFs (Exchange Traded Funds), stocks, bonds, money market funds, certificates of deposit (CDs), cryptocurrency, and more. You can even hold investment real estate in a Traditional IRA.
When To Contribute To a Traditional IRA
A Traditional IRA can be created anytime, but contributions for the current year must be made by the owner's tax deadline, which is typically April 15 of the following year.
For those contributing every year to save for retirement, remember that the evidence indicates that on average it is advantageous to get money in the market as soon as possible, which is why savvy investors try to max out their annual contribution as soon as possible each year around January 1.
Note that contributions must come from earned income, which could include wages, salaries, commissions, bonuses, and business income (if self-employed). The following sources are not eligible:
rental income
interest income
pension income
annuity income
stock dividends
capital gains
Traditional IRA Income and Contribution Limits
Now we'll cover the income and contribution limits for a Traditional IRA. Note that these typically change every year so the numbers here may be outdated depending on when you're seeing this.
Eligibility to make tax-deductible contributions to a Traditional IRA is determined by your Modified Adjusted Gross Income, or MAGI for short, and your tax filing status. If eligible, you can deduct contributions whether or not you itemize deductions on your tax return.
If your income is too high, nondeductible contributions can still be valuable because that money is allowed to grow tax-deferred. If your income is so high that you're also ineligible to contribute to a Roth IRA, you can do a technique called the "Backdoor Roth IRA" where you convert that nondeductible Traditional IRA contribution to a Roth IRA contribution .
At this time in 2023, the annual contribution limit for individuals for a Traditional IRA is $6,500 if below age 50 and $7,500 if age 50 or older, up from $6,000 and $7,000 respectively for 2022.
The current annual income limits to be eligible to fully deduct Traditional IRA contributions in 2023 are $83,000 if single and $136,000 if married filing jointly. Phase-outs for reduced deductions begin at $73,000 if single and $116,000 if married filing jointly.
Also note that your Traditional IRA contribution cannot exceed the income you earned for that year.
How To Open a Traditional IRA
Most brokerages like Schwab, Fidelity, Vanguard, etc. offer Traditional IRAs. Exian clients are able to open Traditional IRAs. Contact us today to open one.
Traditional IRA FAQ's
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There is no "best" Traditional IRA. The account structure and functions are universal regardless of provider; a Traditional IRA at Vanguard is the same as a Traditional IRA at Fidelity. Note, however, that your investment options may be limited to things like CDs if you open an IRA at a traditional bank.
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Contributions to a Traditional IRA are usually tax deductible, depending on income level and tax filing status. Traditional IRA withdrawals are taxed as income.
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There are no income limits to open a Traditional IRA, however there are income limits that determine eligibility to deduct Traditional IRA contributions from taxable income.
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Yes, a Traditional IRA can transfer to beneficiaries at death, but note that withdrawals from the account will still be taxed as income.