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Summary: The benefits of a traditional IRA (individual retirement account) outweigh the drawbacks and can help you build a nest egg for retirement. Take time to prepare for future financial stability by understanding what a traditional IRA is, how it works, and what it can do for you.

Traditional IRA Definition

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How much money a person needs to retire depends on various factors. A person's spending habits, savings, and life expectancy can determine how soon and for how long an individual can enjoy retirement.

Although we can't be certain about any of these things, if there's one thing we know for sure, it's that retirement takes careful planning and a fair amount of money. 

If you see yourself sailing into the sunset rather than hustling during your golden years, then you'll need a solid retirement plan. And there are countless options for socking away money for your future.

You may have come across terms like IRA when searching for investment or retirement accounts, but what exactly is an IRA, and is it the right choice for you? 

In this article, we will take a look at one of the most common retirement accounts — the traditional IRA. 

You'll learn what it is, how it works, how it compares to other IRAs, and how you can open this kind of IRA if and when you're ready.

Plus, we'll answer some frequently asked questions to ensure you have all the information you need going forward. 

What is a Traditional IRA?

The traditional IRA was created by legislation in 1974 to encourage working individuals to set aside a portion of their wages for retirement. 

Traditional IRAs allow individuals to contribute pre-tax dollars to the account where the investments grow tax-deferred until withdrawal. Tax-deferred is the technical way of saying that the money won't be taxed as long as it's in the account.

Contributions made to a traditional IRA may be partially or fully tax-deductible, depending on the account holder's filing status and income.

How Does a Traditional IRA Work?

A traditional IRA allows you to save for retirement with contributions that grow tax-deferred. That means you won't owe taxes on your investments until you withdraw money from the account once you reach retirement age. 

With a traditional IRA, you can invest in various stocks, bonds, and assets without reporting the gains on your taxes each year.  

You may also qualify for a tax deduction for your traditional IRA, depending on your annual income. If you aren't eligible but continue to contribute, the government won't tax your contributions upon withdrawal. 

However, investment earnings and interest is taxable.

Traditional IRA Distributions & Withdrawals

The IRS does not allow you to keep funds in your retirement account indefinitely. You can start withdrawing money as early as age 59 ½ but are required to take the minimum distribution amount by age 72. 

The required minimum distribution (RMD) is calculated by dividing the account's past year-end fair market value by the distribution period or life expectancy. The IRS website has worksheets and additional resources to help determine the RMD. 

If you withdraw money from your traditional IRA before age 59 ½, you could incur a 10% penalty tax on the amount withdrawn. Some situations exclude account holders from paying an early withdrawal penalty, including:

  • If you plan on purchasing, building, or rebuilding a first home for you or a qualified family member (up to $10,000).
  • Childbirth or adoption (up to $5000).
  • Qualified education expenses.
  • Qualified medical expenses, including health insurance, while unemployed.
  • You are disabled or become disabled before distribution occurs.
  • A beneficiary receives your assets after your death.
  • The assets are distributed as a result of the IRS seizing your account.
  • The allocated amount is a return on nondeductible contributions.
  • You are active-duty military for more than 179 days.

Always check with the IRS or a tax attorney to ensure that your situation meets the waiver's qualifications.

Traditional IRA Limits in 2020

The IRS restricts the amount an individual can add to a traditional IRA each year. The 2020 traditional IRA contribution limit is $6000 for those under age 50. 

For account holders 50 and above, the contribution limit is $7000 (standard $6000 + $1000 catch-up contribution).

If you are single and covered by a retirement plan at work, you can still contribute to a traditional IRA. This also applies to married couples who participate in employee retirement plans. 

However, if you or your spouse exceeds certain income levels, you may not be able to deduct the entire contribution.  

If you're married, you and your spouse can also contribute to separate traditional IRAs. The total contributions to you and your spouse's IRAs may not exceed your joint taxable income or the annual contribution limit times two — whichever is less. 

There's no requirement that you must contribute the full amount each year, but keep in mind that the limit applies to all of your IRAs. If your limit is $6000 and you contribute $3000 to a Roth IRA, you'll only have $3000 left to put into the traditional IRA.

Traditional IRA vs. Roth & 401k

If you read our article about the Best Retirement Plans, you may already know about some of the differences between IRAs and employee-sponsored retirement plans.

Let's break it down even further by comparing the traditional IRA to the Roth IRA and 401k.

Traditional IRA vs. Roth IRA

The difference between a traditional IRA and a Roth IRA comes down to when you pay income taxes. 

As you've learned, with a traditional IRA, your contributions aren't taxed until after you withdraw them, so you enjoy tax-free money while saving for retirement. 

A Roth IRA flips the coin by taxing your contributions as you put them in but gives you a tax break in retirement. When it comes time to withdraw, your money will be tax-free, granted your account has been open for at least five years.

A few other key differences:

  • Roth IRAs do not have required minimum distributions.
  • Roth IRA contributions have income limits.
  • You can continue contributing to a Roth IRA after you turn 70 ½ if you have earned income or self-employment wages.

A Roth IRA may benefit you expect to be in a higher tax bracket when you retire, if you're a recent college graduate, or if you're early in your career. 

Traditional IRA vs. 401k

A traditional IRA and 401k are similar in many respects: they're both tax-deferred, penalty-free withdrawals begin at age 59 ½, and the required minimum distribution begins at age 72.

The most significant difference is that the employer manages and contributes to the employee's 401k. 

Some employers offer 401k matching. Investopedia says that typically this means that the employer will match a percentage of your contributions, up to a certain amount of your total salary. 

Another difference of the 401k is that contributions are pre-taxed, and your investments are limited by a plan. The contribution limit is also much higher, at $19,500.

To maximize retirement savings, many people contribute to both a 401k and a traditional IRA.

FAQs

If you've made it this far, then you've learned a lot about traditional IRAs, but you may still have some questions.

Below are some of the most common questions people have regarding traditional IRAs. 

Can I lose money in an IRA?

Since contributing to an IRA is about investing, it is possible to lose money, especially if you're investing in the stock market. This shouldn't deter you, though. 

There may be times when the account balance dips due to stock market highs and lows, but there's much to be said for investing in stocks. Putting contributions towards stocks is a long game that may have temporary losses but offers bigger bucks in the long run. 

A Fidelity study taken after the 2008-2009 financial crisis showed that about 1.5 million people who stuck with their retirement plans and invested in the stock market during the economic downturn ended up with account balances 50% higher than those who sold their stocks. 

No matter where you invest your money, it is highly unlikely that you'll lose the entire balance of your IRA account.

For further reference, you can use a traditional IRA calculator, like the one on AARP, that allows you to calculate what your IRA balance could be worth at retirement. Plugin the numbers, click calculate, and view a report on your estimated balance.

Who is eligible for a traditional IRA?

Anyone with taxable earned income can open a traditional IRA. Earned income is any money you earn in exchange for work. This does not include rent payments, income from investments, unemployment benefits, and Social Security benefits. These are labeled as unearned income. 

You can still open a traditional IRA with unearned income as long as you are also earning taxable income.

Should I contribute to a traditional IRA if I can't deduct it?

Depending on your financial situation, a nondeductible IRA can still be beneficial, as your investment earnings won't go to waste, but keeping track of the after-tax contributions and filing IRS Form 8606 every year can be a pain in the neck.

Other routes to consider:

  • Roth IRA: If you're eligible, a Roth IRA may provide you more benefits than a nondeductible traditional IRA. Both types use post-tax dollars and offer contribution growth. With a Roth IRA, you'll be able to make tax-free withdrawals of your contributions and earnings at age 59 ½. 
  • Match Your Workplace Retirement Plan: If your employer provides 401k matching, you can double your money with a contribution match. 
  • Max Out Your Workplace Retirement Plan: If you max out your employer-sponsored retirement plan, it may make you eligible for an IRA deduction. This is because your contributions to the account will lower your yearly taxable income.

You can still open a traditional IRA with unearned income as long as you are also earning taxable income.

How much money do you need to start an IRA?

Financial institutions like banks, discount brokers, and Robo-advisors have $0 minimums to open a traditional IRA. 

However, always look closely at all of the firm's written material, as some places require an initial deposit to be above a certain amount, and others "hide" steep maintenance fees in their contracts.

You're not required at any time to save the maximum yearly amount. You can budget for your traditional IRA in a way that works best for you. You can even inquire about setting up an automatic deposit so that money instantly gets transferred from your bank to your IRA.   

How to Open a Traditional IRA Account

In today's world, opening a traditional IRA can be as easy as opening your laptop. Follow the steps below for guidance on how and where to open an IRA account. 

Step 1

First, decide if a traditional IRA is the right choice for you. After reading this article, you should have a good idea of how a traditional IRA can benefit you, as well as information on Roth IRAs and employee-sponsored retirement accounts.

Step 2

Choose a financial institution that offers traditional IRAs. These include banks and credit unions, mutual fund companies, online brokers, and Robo-advisors.

Step 3

Depending on where you've chosen to open your account, you'll either meet with someone in person or go to the provider's website and fill out some light paperwork.

Step 4

Next, you'll fund your IRA account. You can do this by transferring funds from your bank account to your IRA account, transferring previous IRA contributions into your new account, or by rolling over an existing 401k.

Step 5

Choose where to invest your money.

Choosing where to invest your money comes down to your needs and goals. If you take the hands-on approach, meaning you want to pick and manage your investments on your own, you can get help from an online broker

Online brokers (aka discount brokers) are usually less expensive than in-person brokers, and they allow you to buy and sell stocks and investments directly through their trading platforms. 

Brokers do have the ability to offer advice on which stocks you should invest in, but they are not financial planners and cannot provide more in-depth financial guidance. 

On the other hand, if you're more comfortable taking a back seat and would rather have someone else choose and manage your IRA, we recommend a Robo-advisor. 

The Robo-advisor acts as an automated financial planning service and provides account setup and services, financial goal planning, portfolio management, and customer service.  

A typical robo-advisor will collect information about your financial situation from you via a survey, offer advice, and select investments that match your preferences. Your Robo-advisor will continue to monitor your IRA and make adjustments over time, as needed.

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What's Next?

There's no time like the present to prepare for the future, and you've taken the first step by reading this article and familiarizing yourself with one of the most common retirement plans — the traditional individual retirement account. 

The traditional IRA is an excellent option for anyone earning income, and it's simple to open an account and start reaping the benefits. 

Not only that, but the contributions provide tax advantages so that you can invest in your future without worrying about paying taxes on your earned income.  

With a traditional IRA, you’ll also have flexibility both in where you open your IRA and where you invest, and most institutions allow you to open and manage your IRA with few to no costs. 

If you're self-employed, earn taxable income, or your income level is higher than what's eligible for a Roth IRA, the traditional IRA is a retirement plan worth considering. 

And of course, you can continue your research by diving into our retirement plan overview and recommendations.  

Are you really prepared for retirement?

Take our quick 10 question quiz to find out if you are truly financially equipped to retire and live the rest of your life happy, healthy, & financially free!


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