What is a 'Traditional IRA'
A traditional individual retirement account (IRA) allows individuals to direct pretax income towards investments that can grow tax-deferred; no capital gains or dividend income is taxed until it is withdrawn. Individual taxpayers are allowed to contribute 100% of any earned compensation up to a specified maximum dollar amount. Contributions to a traditional IRA may be tax-deductible depending on the taxpayer's income, tax-filing status and other factors.
BREAKING DOWN 'Traditional IRA'Traditional IRAs are held by custodians, including commercial banks and retail brokers. The invested funds are placed into different investment vehicles per the account holder’s instruction and based on the offerings available through the custodian. The amount that may be added to a traditional IRA on a yearly basis is restricted to particular maximums depending on age and income levels. The contribution limit for the 2016 tax year is $5,500 for taxpayers under 50 years of age. For people over the age of 50, higher annual contribution limits apply, allowing a contribution of up to $6,500 during the 2016 tax year.
Traditional IRAs as Secondary Retirement Vehicles
When a traditional IRA is secondary to an employer-sponsored retirement plan, additional restrictions to the contribution amounts that can be deducted apply. For example, in 2015, if a taxpayer participated in an employer-sponsored program, such as a 401(k) or a pension program, the taxpayer would only be eligible to take the full IRA deduction if the annual salary received was under $61,000 if he files as an individual or $98,000 if he files jointly with an eligible spouse.
Traditional IRA Distributions
When receiving distributions from a traditional IRA, the income is treated as ordinary income and is subjected to income tax. Distributions can be taken as early as age 59 1/2 and are required to taken no later than age 70 1/2. Funds removed prior to full retirement eligibility incur a 10% penalty and standard income tax rates.
Other variants of the IRA include the Roth IRA, SIMPLE IRA and SEP IRA. An individual can set up a Roth IRA. Unlike a traditional IRA, a Roth IRA does not feature upfront tax-deductible contribution benefits. Distributions on funds contributed to and generated from a Roth IRA are not considered taxable income.
SIMPLE IRAs and SEP IRAs are benefits instituted by an employer and cannot be opened by an individual. Generally, these IRAs function similarly to traditional IRAs, but they have higher contribution limits and may allow for company matching.