What Is a Traditional IRA?
Traditional IRAs (individual retirement accounts) let you invest up to $6,000 of your earned income every year into a retirement account — $7,000 if you’re 50 or older. You don’t have to pay taxes on the money or profits from your investments until you withdraw money from the account.
How Do Traditional IRAs Work?
Traditional IRAs allow you to contribute some of your income to a retirement account you set up through a financial institution or licensed financial professional. Your contributions are allowed to grow without being taxed until you take money out of your account.
In addition, you may be able to partially or fully deduct your traditional IRA contributions from your income taxes, depending on your annual income.
Anyone who has taxable income during the year can contribute to a traditional IRA., but your annual contributions cannot be more than the taxable income you earn in the same year.
When you withdraw from a traditional IRA, the money you take out is taxed as income, based on your current tax rate at the time of the withdrawal. The Internal Revenue Service does not assess any taxes on dividends from your investments or any capital gains taxes on your investments in the IRA.
- Up to 50 Years Old
- You can invest up to $6,000 a year in 2020.
- Age 50 and Older
- You can invest up to $7,000 a year in 2020.
- Age 59 and Six Months
- Any withdrawal you make before turning 59 and six months will stick you with a 10 percent penalty and require you to pay income taxes on the withdrawal. Once you reach this age, the penalty goes away.
- 72 Years Old
- You must begin required minimum distributions (RMDs) — regular withdrawals — when you turn 72 or face a 50 percent penalty.
How to Open a Traditional IRA
Unlike a 401(k) plan, which is offered by an employer, you usually have to open a traditional IRA on your own. You can open them through a variety of financial institutions or financial professionals.
- Traditional IRAs opened through banks tend to be more secure investments, but the trade-off can be a lower return on your contributions. This is because banks tend to limit investments to certificates of deposits instead of stocks and bonds, which can offer higher returns, but can also be more volatile.
- Online Brokers
- Online brokers can allow you greater freedom to select the investments you want included in your traditional IRA. These are only limited to the stocks, bonds and mutual funds available through that broker.
- Robo-advisors automate the process of selecting investments for you, often at a fraction of the cost. Often provided by leading investment firms, the automated systems select investments for your traditional IRA based on your retirement goals, how long you have until retirement and your financial ability to invest over time.
Rules for Distribution and Withdrawal from a Traditional IRA
You can face costly penalties if you take money out of your traditional IRA before you turn 59 and six months, or if you fail to take enough money out after you turn 72. These are based on rules for early withdrawal and required minimum distributions.
Taking money out before turning 59 and six months means you’ll have to pay 10 percent of your withdrawal amount as a penalty. You’ll also have to pay income taxes on the withdrawal based on your current income tax rate at the time.
There are some exceptions to this early withdrawal penalty, but you or your beneficiary will still have to pay income taxes on any funds withdrawn under these exceptions.
- Up to $5,000 for adoption of a child
- Up to $10,000 for a first-time home purchase
- If you become disabled
- If you die and a beneficiary withdraws the money
- Paying for medical expenses that qualify
- Paying health insurance premiums while you are unemployed
- Paying higher-education costs that qualify
- You are in the military and called to active duty for more than 179 days
- You use the withdrawal to pay an IRS tax judgement against you
You are also required to start making regular withdrawals — called required minimum distributions — every year after you turn 72 or face stiff penalties.
The IRS will determine how much your RMDs are. You have to withdraw that amount each year after you turn 72 — the first time by April 1 in the year after you turn 72. Each year after that, you have to make your required minimum distribution by Dec. 31.
If you don’t make RMDs by the required deadlines, you can face a stiff penalty — 50 percent of the amount of your required minimum distribution.
How Traditional IRAs Work with 401(k) and Other Retirement Plans
If you have a higher income and are covered by a 401(k) or another retirement plan at work, you may be limited in how much of your traditional IRA contributions you can deduct from your income taxes. Your deductions can be reduced or completely eliminated.
These limits are based on your modified adjusted gross income (MAGI) which takes into account your adjusted gross income and adds some of your deductions back in. These limits are adjusted each year and apply only if you or your spouse has a retirement plan through your job.
|Tax Filing Status||MAGI (2020)||Deduction|
|Single or head of household||$65,000 or less||Full deduction|
|Single or head of household||More than $65,000 but less than $75,000||Partial deduction|
|Single or head of household||$75,000 or more||No deduction|
|Married filing jointly or qualifying widow(er)||$104,000 or less||Full deduction|
|Married filing jointly or qualifying widow(er)||More than $104,000 but less than $124,000||Partial deduction|
|Married filing jointly or qualifying widow(er)||$124,000 or more||No deduction|
|Married filing separately||Less than $10,000||Partial deduction|
|Married filing separately||$10,000 or more||No deduction|
Alternatives to Traditional IRAs
There are three other types of individual retirement accounts that you may consider as alternatives to a traditional IRA.
Each offers tax advantages of their own that may be a better fit for your retirement planning or financial situation.
- Roth IRA
- Roth IRA contributions are not tax deductible, but withdrawals are tax-free six months after your 59th birthday. You make investments into a Roth IRA with after-tax money and do not pay taxes on your investments as they grow.
- SEP IRA
- Simplified employee pension (SEP) IRAs are set up by an employer or self-employed workers. Employers get a tax deduction for contributions they make. It is similar to a traditional IRA but it allows employer contributions.
- SIMPLE IRA
- Small businesses with 100 or fewer workers can set up Savings Incentive Match Plan for Employees (SIMPLE) IRAs. Employees can contribute a maximum of $13,500 in 2020 and the employer can make either the minimum 2 percent contribution or up to an optional 3 percent contribution.
7 Cited Research Articles
- Coombes, A. (2020, July 10). What Is a Traditional IRA? Retrieved from https://www.forbes.com/advisor/retirement/traditional-ira/
- U.S. Internal Revenue Service. (2020, January 28). Traditional and Roth IRAs. Retrieved from https://www.irs.gov/retirement-plans/traditional-and-roth-iras
- U.S. Internal Revenue Service. (2020, January 15). Traditional IRAs. Retrieved from https://www.irs.gov/retirement-plans/traditional-iras
- U.S. Internal Revenue Service. (2020, January 9). Individual Retirement Arrangements (IRAs). Retrieved from https://www.irs.gov/retirement-plans/individual-retirement-arrangements-iras
- U.S. Internal Revenue Service. (2019, December 4). 2020 IRA Contribution and Deduction Limits Effect of Modified AGI on Deductible Contributions If You ARE Covered by a Retirement Plan at Work. Retrieved from https://www.irs.gov/retirement-plans/plan-participant-employee/2020-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-covered-by-a-retirement-plan-at-work
- Cornell Law School. (n.d.). 26 U.S. Code Section 408 - Individual Retirement Accounts. Retrieved from https://www.law.cornell.edu/uscode/text/26/408
- CNN Money. (n.d.). What Is a Traditional IRA? Retrieved from https://money.cnn.com/retirement/guide/IRA_traditional.moneymag/index.htm