What Is a Traditional IRA?
A traditional IRA (individual retirement account) allows individuals to direct pre-tax income toward investments that can grow tax-deferred. The IRS assesses no capital gains or dividend income taxes until the beneficiary makes a withdrawal. Individual taxpayers can contribute 100% of any earned compensation up to a specified maximum dollar amount.
Income thresholds may also apply. Contributions to a traditional IRA may be tax-deductible depending on the taxpayer's income, tax-filing status, and other factors. Retirement savers may open a traditional IRA through their broker (including online brokers or robo-advisors) or financial advisor.
- Traditional IRAs (individual retirement accounts) allow individuals to contribute pre-tax dollars to a retirement account where investments grow tax-deferred until withdrawal during retirement.
- Upon retirement, withdrawals are taxed at the IRA owner's current income tax rate. Capital gains or taxes on dividends are not assessed.
- Contribution limits exist ($6,000 for both 2019 and 2020 for those under age 50; $7,000 for those 50 and older), and required minimum distributions (RMDs) must begin at age 72.
How Traditional IRAs Work
How Traditional IRAs Work
Traditional IRAs let individuals contribute pre-tax dollars to a retirement investment account, which can grow tax-deferred until retirement withdrawals occur (at age 59½ or later). Custodians, including commercial banks and retail brokers, hold traditional IRAs and place the invested funds into different investment vehicles according to the account holder’s instruction and based on the offerings available.
In most cases, contributions to traditional IRAs are tax-deductible. If someone contributes $6,000 to their IRA, for example, they can claim that amount as a deduction on their income tax return and the Internal Revenue Service (IRS) will not apply income tax to those earnings. However, when that individual withdraws money from the account during retirement, those withdrawals are taxed at their ordinary income tax rate.
The IRS restricts the amount that one may add to a traditional IRA each year, depending on age. The contribution limit for the 2019 and 2020 tax years is $6,000 for savers under 50 years of age. For people aged 50 and above, higher annual contribution limits apply via a catch-up contribution provision, allowing for an additional $1,000 (or a total of $7,000).
Under the SECURE Act, passed in December 2019, account holders may continue to make contributions indefinitely to a traditional IRA.
The maximum amount an individual under age 50 can contribute to a traditional IRA for the tax year 2020 (unchanged from 2019).
Traditional IRAs and 401(k)s or Other Employer Plans
When you have both a traditional IRA and an employer-sponsored retirement plan, the IRS may limit the amount of your traditional IRA contributions that you can deduct from your taxes.
In 2020 for example, if a taxpayer participates in an employer-sponsored program, such as a 401(k) or pension program, that individual, filing as a single person, would only be eligible to take the full deduction on a traditional IRA if their modified adjusted gross income (MAGI) was $65,000 or less, or $104,000 or less if married filing jointly. With MAGIs of $75,000 for singles and $124,000 for married couples, the IRS allows no deductions. In between, there's a partial deduction.
IRA contributions must be made by the tax filing deadline (including any extensions). For example, you can make a contribution to your 2020 IRA through April 15, 2021—or later if you file for an extension. If you are above the limits, you can still contribute post-tax income to a traditional IRA and take advantage of its tax-free growth, but investigate other options, too.
Income tax will ultimately have to be paid on IRA money at the time of withdrawal, subject to one's tax bracket during retirement.
Traditional IRA Distributions
When you receive distributions from a traditional IRA, the IRS treats the money as ordinary income and subjects it to income tax. Account-holders can take distributions as early as age 59½. Starting after age 72, account holders must take required minimum distributions (RMDs) from their traditional IRAs.
Funds removed before full retirement eligibility incur a 10% penalty (of the amount withdrawn) and taxes, at standard income tax rates. There are exceptions to these penalties for certain situations. These include the following:
- You plan to use the distribution towards the purchase or rebuilding of a first home for yourself or a qualified family member (limited to $10,000 per lifetime).
- You become disabled before the distribution occurs.
- Your beneficiary receives the assets after your death.
- You use the assets for unreimbursed medical expenses.
- Your distribution is part of a SEPP program.
- You use the assets for higher-education expenses, or expenses incurred for having or adopting a child.
- You use the assets to pay for medical insurance after you lose your job.
- The assets are distributed as a result of an IRS levy.
- The amount distributed is a return on non-deductible contributions.
- You are in the military and called to active duty for more than 179 days.
It's important for an individual to check with a tax attorney or the IRS to be sure that the particulars of their situation qualify for a waiver of the 10% penalty.
Set by the SECURE Act, which became law in December 2019, the age 72-threshold applies from 2020 onwards. The old RMD threshold of 70½ still applies if you turned that age before Dec. 31, 2019.
Traditional IRAs vs. Other IRA Types
Other variants of the IRA include the Roth IRA, SIMPLE IRA, and SEP IRA. The last two are employer-generated, but individuals can set up a Roth IRA if they meet the income limitations. These individual accounts can be created through a broker. You can check out some of the best options with Investopedia's list of the best brokers for IRAs.
Unlike a traditional IRA, Roth IRA contributions are not tax-deductible, and qualified distributions are tax-free. This means you contribute to a Roth IRA using after-tax dollars, but as the account grows, you do not face any taxes on investment gains. Because you paid taxes on your contributions, you can actually withdraw them, penalty-free, at any time. However, you cannot withdraw earnings until age 59½ without being subject to the 10% early-withdrawal penalty.
When you retire, you can withdraw from the account without incurring any income taxes on your withdrawals. Roth IRAs do not have RMDs. If you don't need the money, you don't have to take it out of your account and worry about penalties for failing to do so. You can also pass the money to your heirs if you don't end up needing to use it.
Roth IRA contributions for 2019 and 2020 are the same as for traditional IRAs: $6,000, unless you are 50 or older and can qualify for the catch-up contribution, which raises the limit to $7,000. The catch is that not everyone qualifies to contribute to a Roth IRA. There are income limitations, with contributions gradually phased out as your MAGI increases.
In 2020, the income phase-out range for Roth contributions for married couples filing jointly is $196,000 to $206,000; for singles and heads of household, it's $124,000 to $139,000. If you earn above those amounts, you can't contribute to a Roth at all.
SIMPLE and SEP IRAs
SIMPLE IRAs and SEP IRAs are benefits instituted by an employer so individuals cannot open them, although self-employed or sole proprietors may. Generally, these IRAs function similarly to traditional IRAs, but they have higher contribution limits and may allow for company matching.
A simplified employee pension (SEP, or SEP IRA) is a retirement plan that an employer or self-employed individuals can establish. The employer is allowed a tax deduction for contributions made to the SEP plan and makes contributions to each eligible employee's SEP IRA on a discretionary basis. Fundamentally, a SEP IRA can be considered a traditional IRA with the ability to receive employer contributions. One major benefit it offers employees is those employer contributions are vested immediately.
A SIMPLE IRA is a retirement savings plan that can be used by most small businesses with 100 or fewer employees. "SIMPLE" stands for "Savings Incentive Match Plan for Employees," and "IRA" stands for "Individual Retirement Account." Employers can choose to make a 2% retirement account contribution to all employees or an optional matching contribution of up to 3%. Employees can contribute a maximum of $13,000 annually in 2019 and $13,500 in 2020; the maximum is increased periodically to account for inflation. Retirement savers age 50 and older may make an additional catch-up contribution of $3,000, bringing their annual maximum to $16,000 in 2019 and $16,500 in 2020.