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pretax income towards investments that can grow tax-deferred; no capital gains or dividend income is taxed until it is withdrawn.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 can 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.
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 maximums depending on age. The contribution limit for the 2017 and 2018 tax years is $5,500 for taxpayers under 50 years of age. For people age of 50 and above, higher annual contribution limits apply, allowing a contribution of up to $6,500 during both the 2017 and 2018 tax years. In the year you reach age 70½ you are no longer eligible to contribute to a traditional IRA.
When you have both a traditional IRA and an employer-sponsored retirement plan, the amount of your traditional IRA contribution that you can deduct from your taxes may be limited. For example, in 2017, 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 his or her modified AGI was $62,000 or less if filing as an individual or $99,000 or less if married filing jointly. With modified AGIs of $72,000 for singles and $119,000 for marrieds, no deduction is permitted. In between, there's a partial deduction.
The limits for 2018 are $63,000/$73.000 and $101,000/$121,000 respectively. Above the limits, you can still contribute post-tax income to a traditional IRA for its tax-free growth, but you should investigate other choices as well.
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 59½. Starting after age 70½, account holders must take required minimum distributions (RMDs) from their traditional IRAs.
Funds removed prior to full retirement eligibility incur a 10% penalty and standard income tax rates. There are exceptions to these penalties for certain situations.
Other variants of the IRA include the Roth IRA, SIMPLE IRA and SEP IRA. Two are employer-generated, but individuals can set up a Roth IRA if they meet the income limitations. Unlike a traditional IRA, a Roth IRA does not feature upfront tax-deductible contribution benefits. However, unlike a traditional IRA, distributions of funds contributed to – and generated from – a Roth IRA are not considered taxable income and there are no RMDs during the account holder's lifetime. (See Roth vs. Traditional IRA: Which Is Right for You?)
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.