What is a Traditional IRA
A traditional IRA (individual retirement account) allows individuals to direct pretax income toward investments that can grow tax-deferred. The IRS assess 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.
How Traditional IRAs Work
BREAKING DOWN Traditional IRA
Custodians, including commercial banks and retail brokers, hold traditional IRAs and place the invested funds into different investment vehicles per the account holder’s instruction and based on the offerings available.
The IRS restricts the amount that one may add to a traditional IRA each year depending on age. The contribution limit for the 2019 tax year is $6,000 for savers under 50 years of age. For the 2018 tax year the limit is $5,500. For people age of 50 and above, higher annual contribution limits apply via a catch-up contribution provision, allowing an additional $1,000 ($7,000 total in 2019; $6,500 total in 2018). In the year you reach age 70½ you are no longer eligible to contribute to a traditional IRA.
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 you can deduct from your taxes. For example, in 2018, if a taxpayer participated in an employer-sponsored program, such as a 401(k) or pension program, the taxpayer would only be eligible to take the full deduction on a traditional IRA if his or her modified adjusted gross income was $63,000 or less if filing as an individual or $101,000 or less if married filing jointly (fully phasing out at $73,000 and $121,000, respectively). With modified AGIs of $73,000 for singles and $121,000 for married couples, the IRS allows no deductions. In between, there's a partial deduction. For the 2019 tax year, the MAGI deductibility phaseout for single filers starts at $64,000 and fully phases out at $74,000. For those married filing jointly the deductibility phaseout begins at $103,000 and fully phases out at $123,000.
IRA contributions must be made by the tax filing deadline (including any extensions). For example, you can make a contribution to your 2018 IRA through April 15, 2019 – 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.
Traditional IRA Distributions
When receiving 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 70½, account holders must take required minimum distributions (RMD) 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:
- 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 medical expenses for which you were not reimbursed.*
- Your distribution is part of a SEPP program.
- You use the assets for higher-education expenses.*
- 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.
Traditional IRAs and Alternative IRAs
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. 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, a Roth IRA does not feature upfront tax-deductible contribution benefits. However, unlike a traditional IRA, the IRS does not (one you reach 59½) tax distributions of funds contributed to – and generated from – a Roth IRA. What's more, there are no RMDs during the account holder's lifetime. With a traditional IRA, you have to take RMDs starting after you turn 70½.
SIMPLE IRAs and SEP IRAs are benefits instituted by an employer and individuals cannot open them. Generally, these IRAs function similarly to traditional IRAs, but they have higher contribution limits and may allow for company matching.