A traditional IRA is a type of individual retirement account that provides your investments with tax-deferred growth. Contributions to a traditional IRA are made pre-tax, and you may be able to deduct some or all of your traditional IRA contributions on your tax return, depending on your income.
How Does a Traditional IRA Work?
With a traditional IRA, your contributions grow tax-deferred. That means you won’t owe capital gains taxes on the investment returns, dividends or interest in the account. You can buy and sell a wide range of assets and asset classes in a traditional IRA, including stocks, bonds, exchange traded funds and mutual funds.
You’ll owe regular income tax on some or all of your contributions and earnings when you make withdrawals from your traditional IRA in retirement. Depending on your annual income, you may be eligible for a tax deduction for your up-front traditional IRA contributions. If you don’t qualify for the tax deduction, then your contributions won’t be taxed when you withdraw them, although any investment earnings or interest will be taxable as regular income.
Who Can Contribute to a Traditional IRA?
Anyone who earns taxable income in a given year can contribute to a traditional IRA, although you cannot contribute more to an IRA than you earn in a year. In 2020 and 2021, you can contribute a maximum of $6,000 per year to a traditional IRA, or $7,000 if you’re 50 or older. The deadline to contribute is the tax filing deadline, so you can contribute until April 15, 2021 to an IRA for tax year 2020.
Who Can Deduct Traditional IRA Contributions From Their Taxes?
If you don’t have access to a workplace retirement plan, like a 401(k), or your annual income is below certain thresholds, you get an income tax deduction for traditional IRA contributions. If your spouse does have access to a workplace retirement plan but you do not, you also may face certain income limitations for a tax deduction. Here are all the limits:
Tax Advantages of a Traditional IRA
Traditional IRAs offer two primary tax advantages: Tax deductions and tax-deferred investment growth.
If your income falls below the thresholds outlined above, deducting contributions can really add up when it comes tax time. Say you earn $75,000 a year and you contribute $6,000 to a traditional IRA. If you qualify, your taxable income for the year is reduced to $69,000. If your marginal tax rate was 22%, your IRA contributions saved you about $1,320 in taxes.
Outside of tax deductions, tax-deferred growth can exponentially increase the value of your investments. According to AllianceBernstein, over 30 years, an investment of $100,000 held in a tax-advantaged account, like an IRA, could grow more than twice as large a comparable investment in a taxable account, like a brokerage account.
Should I Contribute to a Traditional IRA If I Can’t Get a Tax Deduction?
If you can’t deduct your contributions to a traditional IRA, there may be better ways to invest for retirement than a nondeductible traditional IRA. The best plan for you will depend on your financial situation, but in general, you should:
- Contribute enough to get any match in your workplace retirement plan. If your employer offers 401(k) matching, you can instantly double your money with a 401(k) match.
- Max out your workplace retirement plan. If your retirement plan at work has investment options you like and reasonable fees, then consider maxing out your contributions to that plan. (If your workplace plan doesn’t meet those parameters, skip to step 3.) With a 401(k) or 403(b), you can put away up to $19,500 ($26,000 if you’re 50 or older) in 2020. Workplace retirement plans will offer many of the tax advantages of IRAs but with higher contribution limits. And like IRAs, most 401(k)s can be traditional or Roth.
- Max out a Roth IRA, if you can. If you meet income requirements, a Roth IRA may offer you better benefits than a nondeductible traditional IRA. Nondeductible traditional IRAs and Roth IRAs both use post-tax dollars and offer the same tax-free growth. But unlike with traditional IRAs, you can make tax-free withdrawals of your contributions and your earnings starting at age 59 ½ (if your Roth account is at least five years old). With nondeductible traditional IRAs, you will owe taxes on any investment earnings.
- Max out a nondeductible traditional IRA. If you want to invest more for retirement and aren’t eligible for a Roth IRA, then consider a nondeductible traditional IRA. You can leave your money in a nondeductible traditional IRA, and you’ll only pay taxes on earnings when you withdraw from your IRA in retirement. But you may also consider a “backdoor Roth conversion,” a tax move that converts a traditional IRA into a Roth IRA. Regardless of your income, you can convert your nondeductible traditional IRA into a Roth IRA. You may owe some income taxes when you convert your IRA, but you then won’t owe taxes on anything you withdraw from your IRA in retirement.
- File Form 8606. If you make nondeductible traditional IRA contributions, be sure to file Form 8606 with your tax return each year. This will tell you how much money you’ve already paid taxes on so you won’t be double taxed in retirement.
Roth vs Traditional IRA
The main difference between Roth vs traditional IRAs is the timing of the tax bill. With a traditional IRA, you get a tax break in the year you make your contribution, if you’re eligible. That means you will pay income taxes on contributions and any growth they achieved in retirement when you withdraw them. With a Roth IRA, you pay taxes on what you contribute today, but you get a tax break in retirement: All of your money comes out tax-free as long as your account has been open at least five years.
If you expect your tax rate to be higher in the future, contributing to a Roth now might mean you pay less in taxes overall. But if you exceed the Roth income limits or if your tax bill is likely to be lower in retirement, then contribute to a traditional IRA.
You can contribute to both a traditional IRA and a Roth IRA in the same year as long as your total annual contributions don’t exceed $6,000 in 2020 or 2021, or $7,000 if you’re 50 or older. Some financial advisors recommend you diversify your retirement account types to prepare for any future tax environment.
Traditional IRA Withdrawal Rules
When you withdraw from your traditional IRA in retirement, you pay taxes based on your current income tax bracket. Unlike Roth IRAs, these taxes are on your contributions and your earnings. Money can be used penalty-free for any purpose after age 59 ½, the federal retirement age.
Early IRA Withdrawal Rules
Except under certain circumstances, if you withdraw money from a traditional IRA before age 59 ½, you’ll owe income tax on taxable contributions and gains, as well as a 10% early withdrawal penalty, unless you qualify for an exception.
Exceptions to the IRA Early Withdrawal Penalty
You can avoid the 10% early withdrawal penalty if you use money for any of the following reasons:
- First-time home purchase (up to $10,000)
- Birth or adoption of a child (up to $5,000)
- Qualified higher education expenses
- Qualified medical expenses
- Health insurance premiums when unemployed
- Substantially equal payments
- You have died and the funds are withdrawn by a beneficiary
Keep in mind that you will still owe income tax on any withdrawals from your traditional IRA.
Required Minimum Distributions (RMDs)
When you reach age 72, you must start taking money from your IRA. These required minimum distributions (RMDs) must be withdrawn by April 1 of the year after you turn 72. In subsequent years, RMDs must be taken by December 31 of the relevant year. The IRS determines how much you must withdraw each year based on average life expectancy.
There’s a big penalty—50% of the amount not withdrawn—for failing to withdraw RMDs. If you don’t need the RMD for living expenses, you can avoid income tax on your withdrawal by donating the amount to a qualified charitable organization.
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