What is a Traditional IRA, and How Does it Work?

InvestingIRAs

Oct 15

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 simply 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 it’s the right choice for you.

What is a traditional IRA?

A traditional IRA is an individual retirement account that sets out to help fund your retirement. In doing so, you contribute pre-tax money into the account, and both your contributions and earnings grow tax-free.

How does a traditional IRA work?

After opening a traditional IRA, you can invest in many different types of assets within the account including CDs, stocks, bonds, ETFs, index funds, and mutual funds—with contributions and earnings growing tax-free, as previously mentioned. When you withdraw money from the account in retirement, however, you’ll pay taxes on that same amount.

Traditional IRA types

Traditional IRAs come in a variety of forms. Some of the most common include:

SEP IRAs

SEP IRAs are available to those who operate as a sole proprietor or business owner, are in a partnership, or earn self-employment income by providing a service.

Simple IRAs

A SIMPLE IRA behaves similarly to a 401(k) plan but is designed specifically for small businesses and self-employed individuals.

Spousal IRAs

A spousal IRA isn’t a special type of account but in fact just your typical Roth or traditional IRA with the same set of rules. The sole difference lies in the fact that a spousal IRA is opened by your spouse, in his or her name, and has a few distinct eligibility requirements.

Traditional IRA advantages

Deferred taxes

The biggest benefits associated with a traditional IRA are tax-related since these are considered “tax-deferred” accounts: meaning you’ll pay taxes on a later date. Any contributions you make are typically funded with pre-tax dollars, therefore, and earnings also grow tax-deferred until you withdraw them in retirement.

Tax diversification

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 retirement income by complementing any tax-free accounts you may already have.

Additional investment options

Compared to a 401(k) or 403(b) account, an 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 disadvantages

As with any investment, traditional IRAs also come with a few drawbacks:

Retirement taxes

You’ll pay income taxes on both contributions and gains when you make withdrawals in retirement. This can be especially challenging if your income sources aren’t properly diversified.

Early withdrawal penalties

While you can withdraw money from a traditional IRA at any time, you’re required to pay corresponding taxes, and your withdrawal may trigger penalties if you withdraw funds before age 59½.

RMDs

Required minimum distributions (RMDs) are the amount of money the IRS dictates you withdraw from your account every year. Unlike its Roth IRA counterpart, a traditional IRA is subject to RMD rules—meaning you need to make withdrawals upon turning 73 (75 beginning in 2033). Annual withdrawals are then due by December 31st every year thereafter.

Potential tax liability for heirs

If you have a balance in your traditional IRA when you pass away, your heirs will also need to take RMDs from the account—typically over a 10-year period—with this added income potentially placing them in a higher income tax bracket and thus apt to pay more in taxes.

Traditional IRA contribution limits

As with many retirement accounts, a traditional IRA has several rules you’ll need to adhere to such as contribution limits—meaning you can’t just pad the account with any amount of money. A traditional IRA has the same contribution limits as a Roth IRA, reflecting a 2025 maximum annual limit of $7,000 for those under 50 years of age (the threshold does change annually). Those aged 50 or older, meanwhile, can contribute up to $8,000 in 2025.

The extra $1,000 for this older age group is referred to as a “catch-up” contribution, something 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.

Note you can 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 2025 until April 15, 2026.

Traditional IRA income limits

Anyone can open and fund a traditional IRA account given the absence of income limits, but 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, those not participating in a retirement plan at work can deduct their full IRA contribution regardless of income. Alternatively, if you do have an employer-sponsored retirement plan, IRA deductions are limited based on filing status and modified adjusted gross income (MAGI).

More specifically, if you’re a single filer with a MAGI of $79,000 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 $126,000. You can also qualify for partial deductions if you’re single and make between $79,001 and $89,000 or married and filing jointly with a combined between $126,001 and $146,000.

Note that deductions aren’t allowed for incomes exceeding $89,000 (for single filers) or $146,000 for those married and filing jointly.

Traditional IRA penalties

While you can withdraw money from a traditional IRA at any time, 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 age 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 do so via your financial advisor or online brokerage and thus enjoy the ability to choose your investments and potentially reap higher returns—albeit with more risk.

How to contribute to a traditional IRA

You generally need earned income (i.e., income earned through a job) to contribute to a traditional IRA.

How the saver’s credit works

A retirement savings contributions credit (or “saver’s credit”) is designed to encourage people with low-to-moderate incomes to save for retirement, essentially rewarding 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).

In sum: choosing a traditional IRA

How do you know if a traditional IRA is right for you? It’s simple! 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.

Have questions about how an IRA fits into your overall investments? Schedule a FREE discovery call with one of our financial advisors to get them answered.

What people also ask

The 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), with the decision ultimately based on your own unique financial situation and goals.
Yes. 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.
While a traditional IRA is a tax-deferred account (meaning you’ll pay taxes on a future date, contributions are typically funded with pre-tax dollars, and earnings growing tax-deferred until you withdraw them in retirement), a Roth IRA tasks you with making contributions using after-tax money that can then grow tax-free (you also won’t pay taxes on withdrawals made during retirement, assuming the account is at least 5 years old).
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.
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 passed 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.
Due to the SECURE Act 2.0, individuals over age 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.
Contributions beyond annual IRA limits can trigger an IRS penalty, but you’re in fact allowed to backtrack in this case. Those who’ve already filed can remove excess earnings within 6 months and file an amended tax return, while those who haven’t can withdraw excess contributions and earnings received on them (either scenario requiring you to pay taxes on earnings in the absence of 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.
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).