What is a Traditional IRA?

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Definition:

A traditional IRA (individual retirement account) is a tax-deferred investment or savings account designed to help working individuals save for retirement.

🤔 Understanding traditional IRA

A traditional IRA (individual retirement account) is a type of retirement savings account that you may be able to contribute to without having to pay income taxes on your contributions, depending on your income and other factors. In this case, you are taxed on your contributions and gains when you withdraw your money, which typically occurs during retirement. This means you can contribute pre-tax dollars to your IRA, which lowers your immediate tax burden, and you don’t have to pay taxes until you withdraw your money. Withdrawals from a traditional IRA are called distributions and can be taken even while still working. However, the withdrawal will be counted as part of your taxable income, and if you’re under the age of 59½, you may need to pay an additional 10% penalty (or more under specific circumstances).

Example

Imagine a young project manager, Doug, who earns $60,000 a year, wants to save up for retirement. Doug decides to opt for a traditional IRA, so he finds an IRA provider and sets up an account and contributes money every other week. The money invested in his IRA has the potential to grow over time. Eventually, when Doug is ready to retire, he withdraws his money and those withdrawals are taxed as regular income.

Takeaway

A traditional IRA is a type of retirement account that may allow you to receive a tax deduction when you contribute money. Then, during retirement, your qualified withdrawals are taxed like ordinary income.
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What is a traditional IRA?

A traditional IRA (individual retirement account) is a type of retirement savings or investment account. With this type of account, you may be able to deduct your IRA contributions from your taxable income, depending on how much your income is and whether you’re already enrolled in another retirement plan by your employer.

This means that you may not have to pay income taxes on any contributions into your IRA, and instead, you'll pay taxes when you withdraw the money, typically upon retirement.

The contributions you make to your IRA are often deducted from your taxable income for the year (the amount you can deduct changes based on your income and employment benefits), meaning you can often make pre-tax contributions. This incentivizes retirement savings and helps working people contribute more than they may have otherwise been able to. However, maximum annual contributions are limited to a set amount, which changes periodically per the Internal Revenue Service (IRS).

When someone contributes to their IRA, the money can be invested in mutual funds, stocks, bonds, exchange traded funds (ETFs), or certificates of deposit (CDs). But investing through an IRA provides one major advantage to investing without one: Any gains you accrue are usually not taxable until you withdraw your funds. Keep in mind though, all investing involves risk and past performance is not a guarantee of future returns. The value of your IRA may be affected by market fluctuations.

Account holders generally may not withdraw money before the age of 59½ without incurring taxes and a 10% penalty. There are some exceptions allowed by the IRS, such as to pay for unreimbursed medical expenses or to buy a first home.

Traditional IRAs are one type of retirement account along with Thrift Savings Plans, 401(k)s, and Roth IRAs. There are several differences between all of these, but traditional IRAs are unique because an individual can open one without the help of their employer and the contributions can be (within certain income limits) tax deductible and any taxes paid are typically deferred until withdrawn.

How do traditional IRAs work?

Traditional IRAs can be opened by anyone under the age of 70 who earns their income.

Once you open an IRA, you are free to begin contributing money to it. Depending on your adjusted gross income (AGI) — your income less specific tax deductions — and whether you (or your spouse) are already covered by another retirement plan by your employer, you may be able to deduct your contributions from your taxable income, effectively meaning you can make pre-tax contributions.

Single account holders with an AGI over a certain amount are not eligible for a deduction if they already have retirement coverage from their employer and the amount that you can contribute to a traditional IRA is subject to contribution limits. The full regulations on deduction eligibility can be found on the IRS’s website.

The money in an IRA is invested so that it (hopefully) grows over time. IRA funds are typically invested in stocks, bonds, exchange traded funds (ETFs), certificates of deposit (CDs), and/or mutual funds.

Upon withdrawal, referred to as a distribution, account holders will need to pay income tax on their withdrawal. If the withdrawal is made before the account holder is 59½, there may be an additional 10% penalty (or more in certain circumstances).

How do distributions work in traditional IRAs?

Distributions refers to withdrawals from a traditional IRA. Distributions from traditional IRAs can be made at any time, but you will need to include it on your tax return when you do so — which is why traditional IRAs are considered tax-deferred and not tax-free.

If you are withdrawing money from your IRA before you reach the age of 59½, you may be subject to an additional 10% penalty on top of any income taxes you owe. Under certain circumstances, such as if you make a withdrawal within the first two years after opening a SIMPLE IRA plan, you may have to pay as much as 25% in additional taxes.

Once you reach a certain age, you typically need to start taking required minimum distributions.

What about other retirement accounts?

There are several types of retirement plans. Here’s a synopsis of how a traditional IRA compares to each. Note, this list is not an exhaustive comparison, only a brief overview.

  • 401(k): Traditional IRAs and 401(k)s both offer tax-advantaged retirement plans if you meet the requirements, but a 401(k) must be set up by an employer. A traditional IRA, on the other hand, can be set up by anyone under the age of 70 who earns their income. 401(k)s also have higher contribution limits. Employers often match employee contributions to their 401(k), which is known as 401(k) matching.
  • Roth IRA: The main difference between a Roth IRA and a traditional IRA is that contributions to a Roth IRA are not tax-deductible. Instead, account holders get their tax breaks when they make withdrawals, which are tax-free for qualifying distributions above the age of 59½.
  • SIMPLE IRA: A SIMPLE (Savings Incentive Match Plan For Employees) IRA is similar to a 401(k), but it is designed specifically for small businesses. Many businesses consider it a cheaper alternative to other retirement plans while still allowing them to offer contribution matching. Like a 401(k), it must be set up by an employer, but it has lower contribution limits than a 401(k).
  • SEP IRA: A SEP (Simplified Employee Pension) IRA follows all the same rules as a traditional IRA, but it allows employers to make contributions to their employees’ IRAs.
  • Thrift Savings Plan (TSP): The Thrift Savings Plan is very similar to a 401(k), but it’s only available to federal employees, uniformed service members, and civil servants. It can be thought of as the public sector version of a 401(k).

Which retirement plan is best?

There is no clear-cut winner when it comes to the “best” retirement plan. Each option has its own ups and downs, and everyone must plan for their retirement based on their own individual goals and timelines. Not everyone will be eligible for every plan, so it’s often best to consult a professional such as a Certified Financial Planner (CFP).

What are some benefits and drawbacks of a traditional IRA?

A traditional IRA allows some individuals to contribute to their retirement funds and potentially reduce their immediate tax burdens while doing so. Although not everyone is eligible for deductible contributions, those who qualify can deduct their contributions from their taxable income. Plus, any potential gains are not taxed until a withdrawal is made, which typically occurs during retirement. Keep in mind though, withdrawals are required after a certain age. This is called a required minimum distribution.

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New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.

Commission-free trading of stocks, ETFs and options refers to $0 commissions for Robinhood Financial self-directed individual cash or margin brokerage accounts that trade U.S. listed securities and certain OTC securities electronically. Keep in mind, other fees such as trading (non-commission) fees, Gold subscription fees, wire transfer fees, and paper statement fees may apply to your brokerage account. Check out Robinhood Financial’s Fee Schedule for details.

Brokerage services are offered through Robinhood Financial LLC, (RHF) a registered broker dealer (member SIPC) and clearing services through Robinhood Securities, LLC, (RHS) a registered broker dealer (member SIPC). Cryptocurrency services are offered through Robinhood Crypto, LLC (RHC) (NMLS ID: 1702840). Robinhood Crypto is licensed to engage in virtual currency business activity by the New York State Department of Financial Services. The Robinhood spending account is offered through Robinhood Money, LLC (RHY) (NMLS ID: 1990968), a licensed money transmitter. A list of our licenses has more information. The Robinhood Cash Card is a prepaid card issued by Sutton Bank, Member FDIC, pursuant to a license from Mastercard®. Mastercard and the circles design are registered trademarks of Mastercard International Incorporated. RHF, RHY, RHC and RHS are affiliated entities and wholly owned subsidiaries of Robinhood Markets, Inc. RHF, RHY, RHC and RHS are not banks. Products offered by RHF are not FDIC insured and involve risk, including possible loss of principal. RHC is not a member of FINRA and accounts are not FDIC insured or protected by SIPC. RHY is not a member of FINRA, and products are not subject to SIPC protection, but funds held in the Robinhood spending account and Robinhood Cash Card account may be eligible for FDIC pass-through insurance (review the Robinhood Cash Card Agreement and the Robinhood Spending Account Agreement).

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