Traditional IRAs: How Do They Work?

We’ve all heard that saving for retirement is important. But when it comes to the nuts and bolts of building a retirement nest egg, it’s critical to consider where you should tuck these funds. A traditional individual retirement account (IRA) is one place to build your retirement savings in addition to your 401(k) – and yes, you can have both.

In this post we’ll explore what a traditional IRA is so you can decide if it’s right for you.

What Is A Traditional IRA Account?

How Does A Traditional IRA Work?

Who Can Open A Traditional IRA?

If you earn a taxable income for the year, you are eligible to contribute to a traditional IRA. The exception to this rule is that non-working spouses may be eligible to contribute to a traditional IRA based on their spouse’s income.

In 2022, the maximum contribution limit was $6,000. For those over age 50, the maximum contribution limit for 2022 was $7,000. In 2023, the contribution limits have increased to $6,500. Workers age 50 or older have a contribution limit of $7,500 for 2023.

However, the amount you are able to contribute is limited to the amount you earn for the year. For example, if you earn $2,000, then you are only able to contribute up to $2,000 to your traditional IRA.

Benefits Of Traditional IRAs

●      There are no income limits to open an IRA or contribute. It doesn’t matter if you make $20,000 per year or $300,000. Anyone is allowed to open and contribute to a traditional IRA.

●      Contributions are deductible. When you contribute to a traditional IRA, your contributions are tax-deductible depending on your income, up to a specific limit.

●      There is tax-deferred growth. Regardless of your income, your money grows tax-deferred and any gains you make are not taxed until they are withdrawn in retirement.

●      Pay for college expenses. You can use your traditional IRA account, without facing an early withdrawal penalty, to pay for higher education for yourself or any dependents. There is no limit to the amount you can use. Just keep in mind that you’ll have to pay taxes on whatever you withdraw.

●      Purchase a house. You’re allowed to withdraw up to $10,000 for the purchase of a home. You’ll pay taxes on the amount but no penalties.

Drawbacks Of Traditional IRAs

●      Contribution limits. There are limits to the amount you’re allowed to contribute each year. For the tax year 2023, the deductible contribution limit is $6,500 unless you’re aged 50 or older, in which case you can contribute $7,500.

●      Required minimum distributions. Once you reach age 72, you’re required to start taking distributions even if you don’t need the money in retirement.

●      Income limits on deducting contributions. If you or a spouse are covered by a retirement plan through an employer, your ability to deduct traditional IRA contributions starts to phase out at specific income levels as determined by the Internal Revenue Service (IRS).

●      Penalties for early withdrawal. If you withdraw money from your traditional IRA before you reach age 59 1/2, a 10% penalty will be assessed if the withdrawal isn’t a covered exclusion, in addition to any taxes you’ll owe on any gains. Such exclusions include purchasing a home, the birth or adoption of a child, higher education costs and medical expenses.

Who Is Eligible For A Tax Deduction On Traditional IRA Contributions?

The contributions you make to a traditional IRA may be tax deductible. Generally, you are eligible for the tax deduction if your income is below the annual income threshold. However, you might be disqualified from taking the deduction if you or your spouse has access to a workplace retirement plan.

For example, if you have access to an employer-sponsored 401(k), you might not be eligible to claim the tax deduction for IRA contributions.

Traditional IRA Income Limits

As mentioned above, in order to take the deduction, your income cannot exceed the annual income limits for the year. When contributing to a traditional IRA, it’s important to keep these income limits in mind.

If you have access to a retirement plan at work, here are the income limits that may impact your deductions:

If you or a spouse don’t have access to a retirement plan at work, then the income limits will change.

Should You Contribute To A Traditional IRA If You Don’t Qualify For A Tax Deduction? 

Even if you don’t qualify for a tax deduction, you are able to contribute to a traditional IRA. However, a traditional IRA may not be the best retirement savings product for those who don’t qualify for a tax deduction.

Luckily, there are many other ways to save for retirement that might better suit your needs. A few other options include participating in a 401(k) match, maxing out a workplace retirement plan, maxing out a Roth IRA, or investing in a taxable investment account.

Withdrawing From A Traditional IRA

The goal of contributing to a traditional IRA is to be able to use the funds throughout retirement. When you reach the federal retirement age of 59 ½, you’ll be free to withdraw funds from this IRA without any penalties. However, you’ll still have to pay regular income taxes on the funds you withdraw.

If you make a withdrawal from your traditional IRA before the federal retirement age, you’ll encounter the 10% early withdrawal penalty. This 10% penalty fee is charged on top of your standard income taxes.   

Early Withdrawal Penalty Exemptions

The good news is that the early withdrawal penalty from your traditional IRA is waived for certain situations. If you use the withdrawn funds for one of the following reasons, you can skip the early withdrawal penalty:

●      Health insurance premiums when unemployed

●      Qualified medical expenses

●      Qualified higher education expenses

●      First-time home purchase (up to $10,000)

●      Birth or adoption of a child (up to $5,000)

Additionally, a beneficiary can withdraw the funds without a penalty if you pass away and leave them the proceeds of this IRA.

How Do You Sign Up For A Traditional IRA?

If you think a traditional IRA might be the right fit for your situation, there are a few ways you can sign up for this account.

Brokers

Many online brokerage platforms offer traditional IRAs. Signing up is as easy as providing some information about yourself. Once the account is set up with a broker, you are usually in charge of selecting your own investments.

While a broker gives you more flexibility on your investment choices, you might not enjoy having to make all of the decisions.

Robo-Advisors

Popular robo-advisors take the guesswork out of building an investment portfolio. When you create a traditional IRA through a robo-advisor, the automated technology will handle choosing the investments for you. The decisions it makes for your portfolio will be based on your goals and investment timeline.

If you are looking for a more hands-off approach, a robo-advisor is a worthwhile opportunity. But if you prefer DIY investing, you’ll enjoy the flexibility of a broker.

Other Types Of IRAs

A traditional IRA isn’t your only option. Here’s a closer look at some of the other types of IRAs:

●      Roth IRAs: You can contribute to Roth IRAs with after-tax funds. Although the contributions aren’t tax deductible, your earnings and withdrawals are tax-free.

●      SIMPLE IRAs: A Savings Incentive Match Plan for Employees (SIMPLE) IRA allows both employer and employee contributions. Typically, these IRAs come with lower administration costs than a 401(k).

●      SEP IRAs: A Simplified Employee Pension (SEP) IRA is designed for small business owners and self-employed individuals as a retirement savings vehicle. The contributions limits for a SEP IRA are much higher than a traditional IRA.

The Bottom Line On Traditional IRAs

Saving for retirement from an early age is important if you want to have a large enough nest egg available. A traditional IRA might be the right fit for your retirement savings goals. But saving for retirement isn’t the only way to take control of your finances. If you are ready to get in the driver’s seat, download the Rocket Money^SM app today.