Takeaways
- Traditional IRAs are a popular account for individual retirement planning.
- Traditional IRA distributions are taxed upon distribution after you are 59 1/2 years old.
- Traditional IRAs have a contribution limit of $6,500 for the tax year 2023.
- Savers at least 50 years old can contribute $7,500 for the tax year 2023.
- Traditional IRA contributions can be withdrawn, subject to penalties.
You are ahead of the curve if you have already started planning for retirement. Deciding which retirement investments to add to your overall savings matrix can depend on your age, tax bracket, and income level.
Regardless of where you are in your retirement saving journey, exploring retirement plans beyond your employer-sponsored options can be an excellent means to supplement your retirement savings. One of the most common retirement plans is the Individual Retirement Arrangement, or IRA, which consists of the Roth IRA or Traditional IRA.
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What is a Traditional IRA?
A Traditional IRA is a retirement savings account that allows you to contribute taxable income toward your retirement savings, regardless of whether your employer offers a retirement plan. Traditional IRAs are one of the most pervasive retirement savings accounts due to their investment flexibility and tax-advantaged contributions.
Traditional IRAs have their advantages and disadvantages. Consider all of these before deciding to start an account, but we believe Traditional IRAs should be an essential element of any retirement planning effort.
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Advantages of a Traditional IRA
Investment Flexibility
The ability to invest your retirement funds in multiple stocks, bonds, and mutual funds is a critical advantage of the Traditional IRA. Unlike retirement plans such as the 401(k)-retirement plan, which comes with a menu of prescribed investment opportunities, you have much more investment flexibility with a Traditional IRA.
Because you can set up a Traditional IRA with an online brokerage account in a matter of minutes, taking advantage of the benefits of this account is highly accessible, even to those new to investing.
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Smart Tip:
One key point is that an IRA is not an actual investment but an investment vehicle. Once you have deposited funds into your account, select your investment mix (stocks, mutual funds, target date funds).
Lower Contribution Limits
The contribution limits to a Traditional IRA are updated annually by the IRS. As of the tax year 2023, the contribution limit for Traditional IRAs for those below 50 years old is $6,500 and $7,500 for those 50 or older. This additional $1,000 for savers over 50 is called a catch-up contribution [1].
It is important to note that the contribution limit between Individual Retirement Accounts is split between the Traditional IRA and the Roth IRA. Thus, if you contribute $6,500 to your Traditional IRA, you cannot contribute to your Roth IRA.
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Tax-Advantaged Contributions
One of the key advantages of your contributions to a Traditional IRA is that they are tax deductible. Thus, your contributions reduce your taxable income when paying your federal taxes and could reduce your tax liability.
Tax-advantaged contributions provide the opportunity to save more dollars early and accelerate your investing earlier in your professional career. To further maximize tax benefits, contribute to your Traditional IRA and 401(k) retirement plan.
Investment Gains Not Taxed
Another vital benefit of the Traditional IRA is the investment gains are not taxed. Instead, your investment gains accrue and compound over time tax-free. Avoiding taxation gives an extra jolt for your investments compounding over several decades. When you withdraw capital from your traditional IRA, your defined contributions plus investment gains or income (e.g., from dividends) are taxed as ordinary income.
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Distributions Taxed as Ordinary Income
Because contributions are tax deductible now, you will benefit from not having to make tax payments on your earnings today. However, your distributions are taxed as ordinary income in the future.
For those who think their tax bracket will go down in the future, this is great news because you can defer taxes now into the future.
Flexibility on Contribution Timing
Don’t have the $6,500 maximum contribution limit today? Not a problem. Taxpayers can contribute to a Traditional IRA until April of the following tax year.
For example, if you are saving for your Traditional IRA in 2023, you have until April 15, 2024, to reach your limit. This flexibility helps taxpayers meet their savings goals, and you can put financial windfalls, such as an early-year bonus, into your Traditional IRA.
Disadvantages of a Traditional IRA
Deductions Can be Phased Out
You can claim deductions on your federal income tax return for amounts contributed to a Traditional IRA. Depending on whether you qualify, your contribution limit is tax deductible and potentially phased out of claiming your contribution limit.
IRA deduction limits are updated regularly. For the tax year 2023, if you or your spouse have a qualifying retirement plan at work (such as a 401(k)), and you earn more than $116,000 in Modified Adjusted Gross Income (MAGI), the tax deductibility of your contributions begins to phase out. However, if you or your spouse are not covered by retirement plans at work, your contributions are fully tax-deductible unless you earn more than $218,000 in Modified Adjusted Gross Income. At this income level, the tax deductibility of your contributions begins to phase out.
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Smart Tip:
Your Modified Adjusted Gross Income (MAGI) is your gross income minus your eligible tax deductions. If your gross income is higher than your MAGI, you may have contributions that reduce your MAGI to make you eligible for deducting your traditional IRA contributions.
Penalty for Early Withdrawals
As with most retirement accounts, withdrawing funds before a certain point can be financially prohibitive. Early withdrawals before you turn 59 ½ are subject to a 10% penalty. However, some IRS exceptions apply, such as qualified first-time home buyers can take out $10,000 to purchase their house.
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Required Minimum Distributions
Regardless of whether you want to start making withdrawals from your Traditional IRA or not, you must begin taking distributions by April 1, after the year you turn 72 years old. These withdrawals are called Required Minimum Distributions, or RMDs.
Consider these required minimum distributions when planning for retirement. How and when you plan your income during retirement will determine your income bracket, which can affect how much tax you will pay.
Overall, traditional IRAs are essential components of retirement planning and tax planning. They can be particularly useful when taxpayers are on the edge of a tax bracket, and their tax-eligible contributions can push them to a lower tax bracket, reducing their overall tax burden. Traditional IRAs can be helpful retirement savings vehicles because of the tax-advantaged nature of their contributions.
For many people saving for retirement, the pros of the Traditional IRA outweigh the cons. Often it is not a matter of whether it is a good fit but a question of when to start contributions. The Traditional IRA could be just the perfect retirement account for you.
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Smart Summary
Saving money for retirement is part of any well-established financial plan. Depending on when you are saving income for retirement, investing in a traditional IRA plan can add tax-advantaged savings to your portfolio. Contributing to a Traditional IRA, even after you are phased out of your deduction limits, can be advantageous because your funds grow tax-free until your withdrawal in retirement. Whether you are investing through a 401(k) plan, Roth IRA, or Traditional IRA, saving for retirement is a smart money move.
Frequently Asked Questions
There is no income limit for contributing to a Traditional IRA. However, tax-deductible contributions are phased out if you are covered by a retirement plan at work. Your 2023 deduction limits if you are covered by a retirement plan account are different than if you are not covered by a retirement plan account. Additionally, deductions will vary based on your modified adjusted gross income.
Your tax rate will depend on your total taxable income when making withdrawals from a Traditional IRA. You can begin making withdrawals penalty-free after turning 59 ½ years old.
You can withdraw funds. However, this will result in a regular income tax on the taxable amount of your withdrawal plus a 10% federal penalty taken on the entire amount (unless there is an IRS exception).
[1] IRS. 401(k) limit increases to $22,500 for 2023, IRA limit rises to $6,500. Last Accessed September 18, 2023.