The complete guide to understanding the traditional IRA

The Traditional IRA is an effective option for those looking to strategically plan for retirement, offering appealing tax benefits.

This type of account allows you to make contributions before paying taxes, which can reduce your tax burden in the contribution year. However, when you withdraw the funds during retirement, those amounts will be subject to taxation.

One of the main advantages of the Traditional IRA is the flexibility it provides. Anyone with earned income can open an account and start contributing, taking advantage of the opportunity to accumulate funds for the future.

How does a traditional IRA work?

Opening a Traditional IRA is available to anyone with earned income who wants to save for retirement. What sets a Traditional IRA apart from other types of IRAs is the immediate tax advantage you gain from contributing.

For example, if you earn $60,000 and contribute $6,000 to a Traditional IRA, your taxable income for the year is reduced to $54,000 (assuming you qualify for the tax deduction). This results in potential tax savings in the year you contribute.

The best part is that you don’t have to pay taxes on the gains and interest within the Traditional IRA until you start withdrawing the funds, which typically occurs after age 59½. It’s important to note that withdrawing funds before this age can result in penalties and taxes.

You can open a Traditional IRA at various financial institutions, such as brokerage firms, banks, or robo-advisors. With a brokerage, you can invest in a variety of assets, including stocks, bonds, and mutual funds. Banks may offer more conservative options like savings accounts and certificates of deposit (CDs).

For long-term growth, stocks and bonds tend to provide higher returns compared to traditional savings accounts.

Contribution limits for a traditional IRA

The IRS sets annual contribution limits for a Traditional IRA. In 2024, the contribution limit is $7,000 for individuals under the age of 50.

For those aged 50 or older, the contribution limit increases by an additional $1,000, making the total $8,000. These limits apply regardless of whether you also contribute to other retirement plans, such as a 401(k).

Additionally, if you have multiple IRAs, the contributions across all accounts cannot exceed the annual limit. If you are rolling over funds from another retirement account, such as a 401(k), you can transfer the balance without affecting your annual contribution limit.

Benefits of a traditional IRA

There are several key benefits to opening a Traditional IRA:

• Tax deduction: When you contribute to a Traditional IRA, you can often deduct the contribution from your taxable income, resulting in immediate tax savings.
• Tax-deferred growth: Any income or gains you earn from investments in your Traditional IRA are not taxed until you withdraw them, allowing your investments to grow without the burden of yearly taxes.
• No income limits: There are no income restrictions when it comes to contributing to a Traditional IRA. However, there are income limits for tax deductions if you are covered by a retirement plan at work (more on this below).
• Early withdrawal exceptions: While taking money out of a Traditional IRA before the age of 59½ typically results in a 10% penalty, there are exceptions. You can use your IRA for qualified higher education expenses or a first-time home purchase without incurring this penalty, though you will still owe taxes on the distribution.

Eligibility for a traditional IRA

One of the great things about a Traditional IRA is that virtually anyone with earned income can contribute. However, not everyone is eligible for tax deductions. If you or your spouse is covered by a workplace retirement plan, the IRS has income limits that determine how much of your contribution you can deduct.

For example, if you’re single and covered by a retirement plan at work, you can deduct your Traditional IRA contributions if your income is $77,000 or less in 2024.

If your income exceeds this threshold, your deduction is gradually reduced, and you may not be able to claim any deduction at all if your income surpasses $87,000. For married couples, the income limits are slightly higher.

Should you contribute to a traditional ira if you can’t deduct it?

Even if you’re not eligible for a tax deduction, contributing to a Traditional IRA can still be worthwhile. The main advantage is that your contributions will still grow tax-deferred, and you’ll only pay taxes when you withdraw the money in retirement. However, it’s important to note that you’ll need to file IRS Form 8606 each year to track your after-tax contributions.

If you’re unable to deduct your IRA contributions, it might be a good idea to explore other retirement savings options first. For instance, if you’re eligible, a Roth IRA may offer more favorable tax treatment, as qualified withdrawals from a Roth IRA are tax-free.

A Traditional IRA offers significant tax benefits for those planning for retirement. It allows for tax-deferred growth on your investments and immediate tax deductions on contributions, making it an excellent tool for retirement savings.

However, it’s important to understand the rules surrounding income limits, withdrawal penalties, and required minimum distributions.