Understanding a Traditional IRA vs Other Retirement Accounts
Contents
- 1 Understanding Traditional IRAs vs. Other Retirement Accounts
- 1.1 What Is a Traditional IRA?
- 1.2 How Traditional IRAs Work
- 1.3 Traditional IRAs and 401(k)s or Other Employer Plans
- 1.4 Traditional IRA Distributions
- 1.5 Traditional IRAs vs. Other IRA Types
- 1.6 Opening a Traditional IRA
- 1.7 What Is the Difference Between a Traditional IRA and a Roth IRA?
- 1.8 What Are the Rules for a Traditional IRA?
- 1.9 What Are the Different Types of IRAs?
- 1.10 What Are the Disadvantages of Traditional IRAs?
- 1.11 Does a Traditional IRA Grow Tax-Free?
- 1.12 The Bottom Line
Understanding Traditional IRAs vs. Other Retirement Accounts
What Is a Traditional IRA?
A traditional individual retirement account (IRA) lets individuals direct pre-tax income toward tax-deferred investments. The IRS does not tax capital gains or dividend income until the beneficiary makes a withdrawal. Individuals can contribute from qualified earned compensation.
Income thresholds may apply, and contributions may be tax-deductible depending on income, tax-filing status, and other factors. Traditional IRAs can be opened through brokers or financial advisors.
Key Takeaways
- Traditional IRAs allow individuals to contribute pre-tax dollars to a retirement account where investments grow tax-deferred until withdrawal during retirement.
- Withdrawals are taxed at the IRA owner’s current income tax rate upon retirement.
- Account holders should adhere to annual contribution limits and be aware of schedules for required minimum distributions.
- Nonqualified withdrawals from a traditional IRA are subject to income tax and a 10% penalty before age 59½.
- Unlike Roth IRA contributions, traditional IRA contributions are deductible from current taxable income.
How Traditional IRAs Work
Traditional IRAs allow individuals to contribute pre-tax dollars to a retirement investment account, which can grow tax-deferred until retirement withdrawals occur (at age 59½ or later). Custodians, such as banks or brokers, hold traditional IRAs and invest the funds based on the account holder’s instructions.
Contributions to traditional IRAs are tax-deductible in most cases. When individuals withdraw money from the account during retirement, earnings are taxed at their ordinary income tax rate.
The IRS restricts annual contributions to a traditional IRA based on the account holder’s age. The 2023 contribution limit is $6,500 for those under 50 and $7,000 in 2024. Individuals aged 50 and above can make additional catch-up contributions.
The SECURE Act of 2019 removed age restrictions on contributions to a traditional IRA. Anyone with qualifying earned income can contribute regardless of age.
Traditional IRAs and 401(k)s or Other Employer Plans
When individuals have both a traditional IRA and an employer-sponsored retirement plan, the IRS may limit the amount of traditional IRA contributions deductible from taxes.
If a taxpayer participates in an employer-sponsored program such as a 401(k) or pension and files as a single person, the full deduction on a traditional IRA is only available if their modified adjusted gross income (MAGI) is $73,000 or less for 2023 (increasing to $77,000 for 2024). Married taxpayers filing jointly have limits of $116,000 or less for 2023 and $123,000 for 2024.
For singles with MAGIs between $83,000 and $87,000 in 2023 ($136,000 to $143,000 for married couples), no deductions are allowed. The deduction is phased out for MAGIs between the minimum and maximum levels.
IRA contributions must be made by the tax filing deadline, usually around April 15 of each year.
Tax on IRA money is paid upon withdrawal based on the retiree’s tax bracket. Traditional IRAs are often recommended for investors expecting lower tax brackets in retirement.
Traditional IRA Distributions
When individuals receive distributions from a traditional IRA, the IRS taxes the money as ordinary income. Distributions can be taken as early as age 59½.
The age for required minimum distributions (RMDs) from traditional IRAs depends on the individual’s age and birth year. Distributions must begin by April 1 the year after turning:
Withdrawals before age 59½ incur a 10% penalty and taxes. Exceptions include using the distribution for a first home, becoming disabled, or using the assets for medical or educational expenses.
Individuals should consult a tax attorney or the IRS to determine if their situation qualifies for a waiver of the 10% penalty.
Traditional IRAs vs. Other IRA Types
Roth IRAs
Roth IRA contributions are not tax-deductible, and qualified distributions are tax-free. Contributions are made with after-tax dollars, and there are penalties for early withdrawals of earnings before age 59½.
At age 59½, withdrawals from Roth IRAs are tax-free. Roth IRAs have no required minimum distributions. The account holder can pass the money to heirs if not needed.
Contributions are limited based on income, with phased-out contributions for higher earners.
SIMPLE and SEP-IRAs
SIMPLE IRAs and SEP-IRAs are employer-sponsored retirement plans with higher contribution limits and potential company matching.
SEP-IRAs are traditional IRAs with employer contributions that vest immediately. SIMPLE IRAs are retirement savings plans for small businesses with optional employer contributions.
Opening a Traditional IRA
Individuals can open a traditional IRA if they received taxable compensation in the contribution year or if their spouse earned taxable compensation and they will file a joint return. Multiple traditional IRAs can be opened if both spouses have compensation.
Various organizations and financial institutions can assist in setting up a traditional IRA. There is no minimum balance or starting investment required.
What Is the Difference Between a Traditional IRA and a Roth IRA?
The primary difference is the tax treatment of each account. Traditional IRA contributions are deductible, but earnings are taxable. Roth IRA contributions are not deductible, but qualified distributions are tax-free.
There are also differences in withdrawal rules and penalties.
What Are the Rules for a Traditional IRA?
Traditional IRAs are subject to income taxes and a 10% penalty for unqualified withdrawals before age 59½. Annual contributions cannot exceed earned income for the year.
What Are the Different Types of IRAs?
The two most common types are traditional IRAs and Roth IRAs. SEP IRAs, SIMPLE IRAs, and self-directed IRAs are less common.
What Are the Disadvantages of Traditional IRAs?
Traditional IRAs have penalties for early withdrawals and are not tax-free. These accounts are relatively illiquid.
Does a Traditional IRA Grow Tax-Free?
No, traditional IRAs grow tax-deferred. Contributions are tax-deductible, and earnings are taxed upon withdrawal. Roth IRAs offer tax-free growth.
The Bottom Line
Traditional IRAs are a common retirement savings vehicle that allows for tax-deferred contributions and growth. While withdrawals before age 59½ are subject to taxes and penalties, traditional IRAs are advantageous for lower tax brackets in retirement.