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 taxes on your contributions, depending on your income and other factors. In this case, you are taxed on your 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 on any capital gains you make 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 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. In 2020 and 2021, the contribution limit for a traditional IRA is $6,000, so Doug decides to put $500 of his pre-tax income into his IRA every month. That money gets invested with the potential to grow over time. Eventually, when Doug is ready to retire, he withdraws his money and pays any relevant taxes owing on those withdrawals.

Takeaway

A traditional IRA is like a piggy bank...

When you’re a kid and your parents give you an allowance, you don’t pay taxes on that money. In some cases, they may ask you to save up a portion of your allowance until you’re older. If you break open the piggy bank before you’re old enough, your parents will not be happy, and you might be punished. Similarly, in a traditional IRA, you can save your money for retirement without paying taxes for a while, but if you withdraw it early, you might face penalties.

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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 taxes on any income that goes into your IRA or any capital gains taxes until 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. In 2020 and 2021, that’s $6,000. If you’re over 50, you can contribute up to $7,000.

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.

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

Traditional IRAs are one of the most popular types of retirement accounts 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 capital gains 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 at any time through an IRA provider.

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 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.

For example, in 2020, single account holders with retirement coverage from their employer can typically take a full deduction if their AGI is $65,000 or less, and a partial deduction if their AGI is more than $65,000 but less than $75,000. Single account holders with an AGI over $75,000 are not eligible for a deduction if they already have retirement coverage from their employer. The full regulations on deduction eligibility can be found on the IRS’s website.

The amount that you can contribute to a traditional IRA is subject to contribution limits. In 2020 and 2021, the maximum you can contribute to an IRA is $6,000 if you’re under 50 and $7,000 if you’re over 50.

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 and capital gains 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 the age of 70½, you typically need to start taking minimum distributions.

What is the difference between traditional IRAs and other employment plans?

There are several retirement plans that most people consider. Here’s how a traditional IRA compares to each:

  • 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: $19,500 (excluding catch-up contributions) in 2020 and 2021 compared to $6,000 ($7,000 if you’re over 50) for a traditional IRA. 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 with fewer than 100 employees who earned more than $5,000 in the last year and without another retirement plan. 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).

How do I claim my traditional IRA on my taxes?

There are two forms that are used for traditional IRAs.

Form 8606 is used to report:

  • Nondeductible traditional IRA contributions
  • Roth IRA distributions
  • SIMPLE and SEP IRA distributions for those who have made nondeductible contributions to traditional IRAs at some point
  • SIMPLE and SEP IRA conversions into Roth IRAs

Form 5329 is used to report:

  • Early distribution taxes (and exceptions)
  • Excess contribution taxes
  • Taxes from not taking the minimum distribution

What are the traditional IRA contribution limits in 2020?

In 2020, individuals with traditional IRAs can contribute up to $6,000 if they are under 50 and $7,000 if they are over 50.

What are the benefits of a traditional IRA?

A traditional IRA allows some individuals to contribute to their retirement funds and 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.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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