Last Updated on February 2, 2021 by pf team
If you don’t have enough saved yet, a traditional IRA (individual retirement account) may be just the tool you need to power through and build your retirement savings.
The median retirement savings is about $60,000. That doesn’t seem like much when retirement can last decades.
Half of all retirement savers have even less saved.
What is a traditional IRA account?
A traditional IRA is a retirement savings account that offers powerful tax advantages to help supercharge retirement savings.
There are several types of IRAs. Some benefit business owners. Others can help with saving for education expenses.
The traditional IRA has become the most popular choice, however, because its tax breaks benefit a broad group of savers.
Contributions to an IRA are tax deductible but the account isn’t tax free.
Instead, you defer taxes until you withdraw from your IRA. This structure makes an IRA similar to a 401k, which is also a tax-deferred account.
One big difference is in the contribution limits. An IRA has lower contribution limits.
However, if your employer doesn’t offer a 401k or if you want to save outside of your work plan, an IRA is a great choice. You’ll also have more control over your investments.
How does a traditional IRA work?
With a traditional IRA, you can deduct the contributions you make from your taxable income.
There are some limits based on income, however, so high income earners may not get the same tax break.
Taxes on the balance of your account aren’t due until you withdraw from your account. This can give your account decades to grow.
When you withdraw from your account during retirement, only the amount you withdraw is taxable. The rest can continue to grow without a tax burden.
The tax structure of an IRA allows you to invest more money than if you were investing in a taxable account.
Let’s say you want to save $5,000 per year. If you are investing with a taxable account and you are in the 22% tax bracket, taxes reduce the amount you can invest by $1,100.
If you live in a state that has state income taxes, the tax bite can reduce the amount you can invest even further. Several states have income tax rates approaching 10%.
With a traditional IRA, you defer the taxes, so you can invest more than with a taxable account. In most cases, the $5,000 contribution from the earlier example is fully tax deductible.
This means you don’t pay federal or state income taxes on that amount. At least, not yet.
Tax deferral for an IRA means you can postpone taxes until you withdraw from the account.
For example, if you grew your IRA to $200,000 and then took out $20,000 a year at retirement, you would only pay taxes on $20,000. The balance can continue to grow.
FICA taxes, which apply to wages and self-employment income, don’t apply to IRA withdrawals.
However, income tax applies to the distribution amount based on your tax bracket at the time of withdrawal.
Higher income households might not be eligible for a deduction. Income-based phase-outs are common for IRS tax breaks.
However, many high-income households can take a partial deduction. Often, investors can deduct the entire contribution amount.
A deduction reduces taxes but not by the same amount as the contribution. A $5,000 contribution won’t reduce your tax bill by $5,000. Instead, the deduction reduces the amount of income subject to tax. Over time, the savings can be substantial.
Growth fueled by tax-deferred savings
Here’s an example of how tax-deferred accounts can outperform taxable accounts. Let’s compare investments of $5,000 per year in each type of account over 20 years.
With a taxable account, the tax rate reduces the amount you can invest.
We’ll assume a 22% tax rate because it’s the most common bracket. Let’s also assume 8% in state taxes.
The combined taxes reduce the amount you can invest to $3,500 if you’re investing in a taxable account. With the IRA, you can invest the full $5,000.
After 20 years with a 10% average annual return, the taxable account is worth about $205,000. The IRA is worth $286,000.
That’s $80,000 in extra earnings because you chose a tax-deferred IRA. It isn’t quite that simple, though.
You’ll still pay taxes as you withdraw from the IRA. However, because you only pay taxes on the amount you withdraw, you’ll still come out ahead with the IRA when compared to the taxable investment account.
The difference in overall performance can be even more dramatic if you invest more or if you have a longer investment horizon.
After 30 years, the taxable account would be worth $472,000 and the traditional IRA would be worth $822,000. Compound interest can work wonders given enough time.
In a taxable account, you also have to pay taxes on every taxable event. If a stock you own issues a dividend, you pay taxes.
If your mutual fund issues a distribution, you pay taxes. Taxes are due even if you reinvest the dividend or distribution.
This creates a tax day cash crunch for many investors and works against savings goals. A traditional IRA lets you bypass tax bills for now, allowing you to reinvest your earnings.
Lower tax rate in retirement
Traditional IRAs can also have lower overall tax rates. We have a progressive tax system in the U.S., so higher earners pay higher tax rates.
However, in retirement, tax rates often fall because income is lower.
In an IRA, both the money you invest and growth in the account are tax-deferred until withdrawal, which usually happens during retirement.
This can mean a lower tax rate for your withdrawals. However, there is no guarantee that this will be the case.
Since the federal income tax’s introduction in 1913, tax rates and brackets have changed often, sometimes dramatically.
Invest in stocks, bonds, mutual funds, and more
Traditional IRAs can hold nearly any kind of investment but some investment types have rules attached and some types are disallowed altogether.
Most people use their IRA to invest in stocks, mutual funds, bonds, and ETFs.
Mutual funds can be a great choice because the tax-deferral of an IRA negates the impact of taxable events within the fund, like dividends and distributions.
You won’t pay taxes on these items. Instead, you pay taxes on the amount you withdraw from your IRA, often decades later.
Although IRS rules for what you can hold in an IRA are broad, there are also several prohibited investments.
- Antiques and collectibles: The IRS doesn’t allow coins in an IRA except for special types of gold bullion. They also disallow artwork and other collectibles.
- Personal real estate: IRS rules allow real estate held for investment in an IRA account. However, there are strict rules that govern the investment. IRS rules don’t allow real estate bought for personal use in an IRA account.
- Life insurance: With a small exception for qualified plans, IRS rules prohibit holding life insurance policies in an IRA.
- Derivatives: Lawmakers designed IRAs as a safe way to save for retirement. Some types of derivatives aren’t as safe as other investment types and IRS restrictions prevent their use. IRA providers may also block some options trading.
Some investment types require a special IRA, called a self-directed IRA. Outside of a handful of investments that IRS rules prohibit, an IRA provides much more freedom than other retirement accounts, like 401k plans or 403b plans.
How to open a traditional IRA?
Opening a traditional IRA account isn’t difficult, but there are a few things to consider first.
If you open an IRA with an online broker, you’ll want to learn about their fees and which investments they allow.
The investments allowed by the broker can be key. Expect to find support for trading stocks and ETFs with all major online brokers.
Mutual funds can be trickier, however. Some brokers don’t have a wide selection of funds. In other cases, the fund you want may not be available through that broker.
Invest some time in research before opening an IRA if you have strong investment preferences.
Most online brokers offer stocks and mutual funds but you aren’t limited to brokers. You can also open an IRA with a mutual fund provider.
You might even save money on transaction fees by starting your IRA with a fund provider instead of a broker.
Vanguard and Fidelity are well-known examples of fund providers that offer traditional IRA accounts direct to investors. You can also open an account with a full-service broker.
If you prefer a more hands-off approach, several online brokers also have brick-and-mortar locations. Charles Schwab and TD Ameritrade both have a large retail presence.
In today’s high-tech world, robo-advisors may be the perfect choice. A robo-advisor is a service that builds a portfolio based on your goals.
The service also adjusts your investments automatically, buying or selling as needed. Because robo-advisors are, well, robots, management costs are low.
Consider account fees trading costs
Expect to pay a small annual fee with some IRA providers. This fee covers paperwork costs but the expense ratio for funds doesn’t include this fee.
As part of the service, the IRA provider will file Form 1099-R and send you a copy of Form 5498.
Trading fees can put a dent in returns, so consider the trading costs as part of your decision.
Also consider management costs. Management fees of 0.25% to 1% (or even higher) are common for managed portfolios.
If your portfolio also holds mutual funds, a separate management fee may apply to your investment in the fund. While each fee seems small, they can add up.
Who can contribute to an traditional IRA?
IRS rules control who can contribute to an IRA. First, you must be under age 70 ½ to contribute to a traditional IRA.
At age 70 ½, IRS rules require you to start withdrawing, which is why you have to have your account opened before that age.
At the other end of the spectrum, even kids can have an IRA. However, they also need earned income.
This rule applies to people of all ages. You can’t contribute money you had saved if you didn’t earn more than that amount during the year.
In some cases, your spouse’s income can qualify as earned income for an IRA. For high earners, income doesn’t affect your ability to contribute to an IRA.
However, if you also have a 401k or another qualified plan, IRS rules may limit the amount you can deduct or may disallow deductions.
IRA account types
There are several types of IRAs. For individuals, traditional and Roth IRAs are the most common. For business owners or self-employed workers, SEP, SIMPLE, and self-directed IRAs are popular choices.
- Traditional IRA: A traditional IRA offers tax-deductible contributions and tax-deferred savings. In a crowded field of IRA choices, traditional IRAs remain the most popular choice. Nearly every household can benefit from the unique tax advantages offered by traditional IRAs.
- Roth IRA: With a Roth IRA, you can’t deduct your contributions but your withdrawals are tax free. Another attractive feature of a Roth IRA is that you can withdraw your principal without a penalty.
- Spousal IRA: Traditional IRAs require earned income, which could be unfair to stay-at-home spouses. A Spousal IRA allows a spouse to contribute on behalf of the spouse that doesn’t have a qualifying income.
- Non-deductible IRA: Making more money is great, but a higher income can affect your ability to deduct your IRA contributions. A non-deductible IRA focuses on this issue. You still can’t deduct your IRA contribution, but a non-deductible IRA shelters income from investments until you withdraw. A non-deductible IRA is a good choice for those who don’t qualify for a Roth IRA.
- SEP IRA: A SEP IRA is a simplified employee pension. With a SEP IRA, business owners can contribute toward their retirement savings and can also contribute toward their employee’s retirement.
- Simple IRA: A simple IRA stands for Savings Incentive Match Plan for Employees. Similar to a SEP IRA, business owners can contribute to their retirement savings and those of their employees. A simple IRA offers a streamlined way to provide retirement benefits.
- Self-directed IRA: A self-directed IRA is similar to a traditional IRA. However, a self-directed IRA can hold different asset types. For example, a self-directed IRA can hold businesses, farms, and real estate.
- Education IRA: An education IRA helps families save for education expenses. Much like a Roth IRA, you can’t deduct contributions made to an education IRA. However, you’ll enjoy tax-free withdrawals. This structure can help stretch college savings further. You might also know an education IRA as a Coverdell Education Savings Account.
Advantages of traditional IRA retirement accounts
Traditional IRAs bring attractive advantages that can help build your nest egg faster.
- Tax-deductible contributions: In most cases, you can deduct the contributions you make to your IRA. Don’t underestimate the value of this benefit. Over time, the difference to your account balance can be hundreds of thousands of dollars.
- No income limits: You can contribute to a traditional IRA regardless of your income. Your IRA then shelters your earnings until withdrawal.
- Tax-deferred growth: Taxes on investment income can put a damper on overall returns. With a traditional IRA, you won’t pay taxes on earnings or gains until you withdraw from your account. For many households, this also means a lower tax rate applies.
- Investment flexibility: 401k accounts limit your investment choices. In many cases, you can only choose from mutual funds with high fees. Traditional IRAs open up a new world of possibilities. Most IRAs offer stocks, ETFs, mutual funds, and more. Having more choices can also mean lower management costs. For example, ETFs often have much lower expense ratios when compared to mutual funds but often aren’t available with 401k plans.
Disadvantages of traditional IRA retirement accounts
They never promised you a rose garden. Traditional IRAs have some characteristics that can make them a less-than-perfect choice for some investors.
- Limited investment time period: You can contribute to a traditional IRA until age 70 ½, after which you have to withdraw or face a tax penalty. Taxable investment accounts and Roth IRAs don’t have this limitation. You can add to your investment in these accounts at any age.
- Taxes during retirement: Taxes are no fun any time but they can be particularly unwelcome during retirement. Federal taxes apply to withdrawals from a traditional IRA as regular income. This can sting during retirement when the challenge is to make savings last. By comparison, with a Roth IRA, you can withdraw your savings tax free.
- Required minimum distributions: IRS rules force retirement savers to withdraw from their accounts at age 70 ½. The IRS schedule may or may not match your schedule.
- Might not be deductible: The tax deduction is one of the biggest draws of a traditional IRA. However, many households may not be able to deduct contributions at all. In other cases, IRS rules only permit partial deductions. There’s a silver lining, though. Even when income or filing status phase out deductions, a traditional IRA defers taxes for mutual funds and other investments that generate taxable income.
How your money grows in a tax-deferred traditional IRA at 10%
If you have time on your side, compound interest can work magic in a traditional IRA account. Here’s what the growth can look like over time with a 10% annual return.
Since its inception, the S&P 500 has rewarded investors with an average annual return of about 10%.
In a taxable account, the tax bite can reduce growth. In a traditional IRA, you don’t pay taxes until you withdraw. Your investment can sail ahead without a tax headwind.
Note the last column. Yes, $20,000 can grow to nearly a million dollars, given enough time and consistent earnings.
Choosing an index fund or managed fund can help reduce volatility and ensure that you’re well diversified.
Traditional IRA income limits
You can contribute to a traditional IRA regardless of how much money you make. However, you may not be able to deduct all of your contributions.
If you’re at the higher end of the income scale, you can’t take a deduction at all.
It’s important to consider income limits when choosing the right type of IRA for your needs.
For example, some people can’t contribute to a Roth IRA because they make too much money. A traditional IRA doesn’t have this limitation.
Traditional IRA contribution limits
Along with income considerations, you’ll want to pay close attention to how much you contribute to your traditional IRA.
The annual contribution limits change periodically, so always check before making your contribution.
The IRS taxes excess contributions at 6% per year and it’s not a one-time tax. The tax applies for every year that the overage remains in your IRA account.
It’s also important to know that you can’t contribute more than you earn for the year. If your earned income was $3,000 for the year, that is the most you can contribute to a traditional IRA.
For 2019, the contribution limit is $6,000. If you’re over age 50, you can contribute an additional $1,000 as a catch-up contribution.
Contribution limits don’t apply to rollovers. If you have $40,000 in a 401k from a previous employer and want to start an IRA, you can rollover the entire balance without a penalty.
Traditional IRA tax deduction
Depending on your income and your filing status, often you can deduct your contribution. Your IRA plan provider provides the amounts you’ll need when completing your tax return.
They’ll also file the required forms with the IRS. If you contribute $5,000 and make $50,000 per year, it’s likely that you can deduct the entire contribution.
In most cases, you can deduct the amount of your contribution from your state taxes as well.
Most of the 43 states that have a state income tax follow the federal rules for deducting IRA contributions. However, there can be a catch for some households.
If you or your spouse have a 401k or another qualified plan and you contributed to the plan that year, the amount you can deduct for IRA contributions may be reduced.
The IRS also looks at employer contributions, so if you didn’t contribute but your employer contributed to your 401k, that can trigger a reduced deduction.
Like many IRS deductions, the IRA deduction follows a phase-out schedule based on income.
Filing status can also affect eligibility. If you’re single or filing as head of household and your modified adjusted gross income is $64,000, you can deduct 100% of your contribution to a traditional IRA.
Couples filing jointly with a modified adjusted gross income of $103,000 can also take a full deduction.
If your income is higher than these figures, IRS rules phase out part or all of the deduction.
By now, you’re probably wondering what a modified adjusted gross income (MAGI) is. Your MAGI adds back some deductions to get a more accurate snapshot of your income.
The IRS also uses MAGI to determine eligibility for a Roth IRA.
Q&A about traditional IRA accounts:
What is the difference between a Roth IRA and a traditional IRA?
The primary difference between a Roth IRA and a traditional IRA is the tax treatment of your investments. With a Roth IRA, the money you invest isn’t deductible.
However, when you withdraw from a Roth IRA, the withdrawal is tax free. With a traditional IRA, your contribution is tax deductible and you pay taxes on the money you withdraw.
There are also differences in withdrawal rules and eligibility for a Roth IRA. Income can affect eligibility for a Roth IRA.
Is a traditional IRA qualified or non-qualified?
A traditional IRA is not a qualified plan. The term qualified plan refers to plans governed by the Employee Retirement Income Security Act (ERISA).
Qualified plans include 401k plans and pension plans. A traditional IRA can have similar tax benefits to a 401k but is not an employer plan, so it is a non-qualified plan.
Who can make a fully deductible contribution to a traditional IRA?
Most people can deduct up to the full contribution limit for a traditional IRA. Contribution limits for 2019 are $6,000 per year if you’re under age 50 or $7,000 per year if you’re over age 50.
However, if you or your spouse have a retirement plan at work and have a modified adjusted gross income (MAGI) of $64,000 per year or more, the amount you can deduct may be reduced.
Married couples filing jointly have a higher income limit before deductions phase out. Married couples filing separately have more stringent restrictions on IRA tax deductions.
What is an inherited traditional IRA?
Sometimes called a beneficiary IRA, an inherited IRA is an IRA that changes ownership when the owner dies.
A 401k plan can also be an inherited IRA if you roll over the money from the plan into an IRA. With an inherited IRA, the IRA can remain tax-deferred under certain circumstances.
What are the IRA withdrawal rules?
For a traditional IRA, you can withdraw from the IRA without a penalty at age 59 ½.
Withdrawals before age 59 ½ may be subject to a tax penalty equal to 10% of the withdrawal amount.
IRS rules require that you withdraw from your account beginning at age 70 ½.
The required minimum distribution amount beginning at age 70 ½ can vary based on age and account balance.
How do you convert a traditional IRA to a Roth IRA?
There are 3 ways to convert a traditional IRA to a Roth IRA. The most common is a rollover, which is a simple process in most cases. With a rollover, you take a distribution from your traditional IRA and then deposit the money into a Roth IRA.
You must transfer the funds within 60 days to avoid penalties if you’re under age 59 ½. As part of the conversion, you’ll also have to pay taxes on the distribution. Withdrawals from the new Roth IRA are tax free after age 59 ½.
Can you have a Roth IRA and a traditional IRA?
You can have both a traditional IRA and a Roth IRA. Contribution limits apply to all IRA accounts combined.
For example, for someone under age 50, the contribution limit is $6,000 per year.
You might contribute $4,000 to the traditional IRA and $2,000 to the Roth IRA. The $2,000 Roth contribution is not deductible.
Can I open a traditional IRA if I have a 401k?
You can have both a traditional IRA and a 401k or similar plan. However, if you or your employer contributed to a 401k during the year, you may not be able to deduct your entire IRA contribution.
Should I contribute to a traditional IRA if I make too much money?
If you make too much money to deduct your contributions, there are still benefits to using an IRA instead of a taxable account. Earnings inside the IRA, like dividends and distributions, are tax deferred.
In a taxable account, you’d have to pay taxes on these earnings.
With mutual funds, in particular, the taxes can put a dent in your account growth. A traditional IRA shelters you from these taxable events.
IRS rules also allow you to withdraw the amounts you’ve contributed with after tax money without paying taxes on that money twice.
However, the gains from those contributions are taxable as regular income when you withdraw.
How can I avoid paying taxes on a traditional IRA?
There are a few strategies that can avoid or reduce taxes on a traditional IRA. If you donate part of your IRA to a charity, there is no tax liability on the donated amount.
You can also move to a state that doesn’t tax IRA withdrawals.
Seven states don’t have an income tax and several other states exempt retirement income below a certain amount.
This won’t reduce your tax burden to zero because federal income taxes still apply, but it can be a successful way to stretch your savings.
It’s also worth noting that you can withdraw after-tax contributions without paying taxes.
Because you can deduct contributions to a traditional IRA, you can put more money to work. And you can repeat the process year after year for decades.
Depending on how much you invest and for how long, investment performance combined with tax-deferred growth can drive account values up much faster than with a taxable account.
A traditional IRA brings new opportunities to nearly any type of investment, but it can be particularly helpful if you’re buying mutual funds or stocks that pay dividends.
In a taxable account, earnings from these assets create a tax liability that investors often must pay out of pocket. A traditional IRA defers the taxes on earnings in your account.
This leaves you free to reinvest dividends or distributions as you choose and leaves you with more money to invest.