What is a Traditional IRA and How to Open One
While nobody will argue the importance of saving for retirement, debates abound regarding the best way to do so: especially given the plethora of options available. From 401(k) and health savings accounts (HSAs) to Roth IRAs and real estate, a one-size-fits-all approach to fund your retirement doesn’t exist. Rather, it all depends on your own individual circumstances. Let’s dive into one such option—traditional IRAs—to help understand if this is right for you.
What is a traditional IRA, and how does it work?
Simply defined, an IRA is an account designed specifically to help fund your retirement: allowing you to invest in many different types of assets within the account including stocks, bonds, ETFs, and mutual funds. Although many types of IRAs are available, the two most common are traditional and Roth IRAs.
Traditional IRAs boast immediate tax breaks as the account is typically funded with pre-tax dollars. Conversely, Roth IRA contributions are generally made with after-tax dollars.
Why should you choose a traditional IRA?
The largest benefits associated with a traditional IRA are tax-related, as these are considered “tax-deferred” accounts: meaning you’ll pay taxes on a later date. Therefore, any contributions you make are typically funded with pre-tax dollars, and earnings can also grow tax-deferred until you withdraw them in retirement.
These tax benefits are very appealing to investors, especially those (most of us) who find it difficult (if not impossible) to predict what their tax bracket will look like during retirement. More specifically, these breaks help diversify your retirement income by complementing any tax-free accounts you may have.
Compared to a 401(k) or 403(b) account, your IRA generally features more investment options as you can invest in the stocks, bonds, mutual funds, and/or ETFs of your choosing. Moreover, IRAs offer some early-withdrawal exceptions a 401(k) doesn’t such as the ability to withdraw money for school or fund a first-time home purchase.
Traditional IRA contribution limits
As with many retirement accounts, a traditional IRA features several rules you’ll need to adhere to. One such rule is contribution limits, meaning you can’t just pad your account with any amount of money.
A traditional IRA has the same contribution limits as a Roth IRA. If you’re under 50 years of age, the maximum annual contribution limit is $7,000 for 2024 (limits do change annually). If you’re age 50 or older, you can contribute up to $8,000 in 2024.
The extra $1,000 for this older age group is referred to as a “catch-up” contribution, which the IRS offers to encourage savings and help ease the financial burden of retirement: especially for those who didn’t save enough when they were younger. This amount will likely be tweaked annually due to cost-of-living adjustments.
You can also continue to make contributions for the previous year up until the income tax deadline. In other words, you can do so (in any amount, up to the limit) for 2023 until April 15, 2024.
Traditional IRA income limits
Anyone can open and fund a traditional IRA account given the absence of income limits. However, if you’re seeking tax-deductible contributions, the IRS does have income restrictions based on how much you earn and whether you or your spouse currently participate in other qualified retirement plans—such as a 401(k).
For example, if you’re not participating in a retirement plan at work, you can deduct your full IRA contribution regardless of your income. Alternatively, if you do have an employer-sponsored retirement plan, IRA deductions are limited based on your filing status and modified adjusted gross income (MAGI).
More specifically, if you’re a single filer with a MAGI of $77,000 or less and participate in a plan at work, you can deduct your full traditional IRA contribution. For those filing jointly, the MAGI threshold to receive a full tax deduction is $123,000.
You can also qualify for partial deductions if you’re single and make between $77,001 and $86,999 or married and filing jointly with a combined between $123,001 and $142,999.
Note that deductions are not allowed for incomes exceeding $87,000 (for single filers) or $143,000 for those married and filing jointly.
IRAs and required minimum distributions (RMDs)
Since a traditional IRA is a tax-deferred account, Uncle Sam requires you to pay taxes on your asset. This is precisely where required minimum distributions (RMDs)—the minimum amount of money you must withdraw from an IRA by April 1st the year after you turn 73 (75 starting in 2023)—come into play. Annual withdrawals are then due by December 31st every year thereafter.
Traditional IRA penalties
You can withdraw money from your traditional IRA at any time. However, know that you’re required to pay corresponding taxes and your withdrawal may trigger penalties (depending on timing). For example, an early-withdrawal penalty of 10% is generally assessed on those who withdraw money from their traditional IRA before the age of 59½.
However, as with most rules, exceptions can help you skirt the 10% penalty including:
· Using funds for a first-time home purchase (up to $10,000)
· Using a distribution in the year you become a parent via birth or adoption (up to $5,000)
· Paying for qualified higher education for you or an immediate family member
· Having unreimbursed medical expenses that exceed 7.5% of your adjusted gross income
· Acting as the beneficiary of a deceased owner
· Becoming completely and permanently disabled
· Being called up for active military duty (for more than 179 days)
Note that the SECURE Act 2.0 has expanded these circumstances to include emergency expenses and domestic abuse.
How to open a traditional IRA
You can open a traditional IRA at almost any bank, credit union, or other financial institution: with the former two options typically taking shape as an IRA certificate of deposit (CD). This is sometimes a good option for people who want to minimize their risk and guarantee their return.
Alternatively, you can also open a traditional IRA through your financial advisor or online brokerage and thus enjoy the ability to choose your investments and potentially reap higher returns—albeit with more risk.
Just note you generally need earned income—such as wages, salaries, and/or other taxable employee compensation—to contribute to an IRA.
Other considerations
If you have a spouse who is unemployed or has very little income, you can open a spousal IRA to help accelerate your retirement savings and sidestep the earned income requirement.
A spousal IRA is essentially a traditional IRA—with the same annual contribution and income limits and catch-up contribution provisions—but the employed spouse makes contributions on behalf of his or her unemployed partner. Spousal IRAs are established in the name of the individual spouse, and the couple must file a joint tax return.
Switching gears, a retirement savings contributions credit (or “saver’s credit”) is designed to encourage people with low-to-moderate incomes to save for retirement. This essentially rewards participants who contribute to a qualified retirement account—including traditional IRAs—with a tax credit of up to $1,000 ($2,000 for married couples).
Akin to Roth IRAs, you aren’t allowed to take out a loan from a traditional IRA unlike with other retirement vehicles—such as a 401(k).
In sum: choosing a traditional IRA
How can you determine if a traditional IRA is right for you? This option often makes the most sense if your employer doesn’t offer a retirement plan and/or you maxed out your 401(k) and want to save additional pre-tax money.
FAQs
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This amount can vary depending on the provider you choose (many in fact have no minimum requirement, allowing you to open an IRA with as little as $0). Ultimately, the decision about how much money to contribute to your IRA is based on your own unique financial situation and goals.
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As with any investment, it is possible to lose money in an IRA often due to market volatility, poor investment selection, early withdrawals and investments fees, or a combination of these.
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A traditional IRA is a tax-deferred account, meaning you’ll pay taxes on a future date and contributions are typically funded with pre-tax dollars (with earnings growing tax-deferred until you withdraw them in retirement).
With a Roth IRA, on the other hand, you make contributions using after-tax money which can then grow tax-free. You also won’t pay taxes on withdrawals made during retirement, assuming the account is at least five years old.
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This is done via a Roth IRA conversion and involves rolling over all (or a portion) of your balances from either an existing traditional IRA, SEP, or SIMPLE IRA into a Roth IRA. One of the most common reasons for doing so is the ability to enjoy tax-free withdrawals in retirement; however, keep in mind corresponding tax implications are involved.
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Generally speaking, designated beneficiaries—those who aren’t a spouse, minor child of the deceased owner, chronically ill or disabled, or more than 10 years younger than the account owner—must follow the 10-year rule when inheriting an IRA. This requires you to withdraw funds from the inherited account within 10 years of the IRA owner’s death (e.g., if an IRA owner passes away in 2024, inherited IRA funds must be fully distributed by December 31, 2034).
If you’re the sole beneficiary of your spouse’s IRA, click here to check out a few options in this regard.
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Due to the SECURE Act 2.0, individuals over the age of 70½ can now continue making IRA account contributions provided they’ve earned income. The impetus behind this measure is to incentivize those working later in life to save additional money and continue to build their nest egg over a longer period of time.
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Contributions beyond annual IRA limits can trigger a penalty from the IRS, but you are allowed to backtrack in this case. If you’ve already filed, you can remove the excess earnings within six months and file an amended tax return. If you haven’t already filed, you can withdraw excess contributions and earnings you receive on them (either scenario requires you to pay taxes on earnings, but you won’t encounter a penalty). Another option is to reduce the following year’s contribution by the excess amount, but keep in mind you’ll pay a 6% penalty on the excess contributed for every year it remains in the account.
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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.
Disclosures
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.