What Is a Traditional IRA? An Introductory Guide
A traditional IRA (individual retirement account) is a type of retirement plan that allows you to save your money for retirement by contributing pre-tax dollars to your account and letting them grow tax-deferred.
Generally, anyone can open and contribute income to a traditional IRA. Unfortunately, it is not always true that these contributions will not be taxed.
Nevertheless, a traditional IRA can be a great way to help you save for retirement. Even if you have an employer-sponsored plan like a 401(k) plan, you can benefit from opening an IRA.
Who Is Eligible for a Traditional IRA?
Generally, anyone who earns income can open and make contributions to a traditional IRA retirement plan. However, you may not be eligible to deduct money you put in from your taxes.
If you don’t have a work-sponsored retirement plan, you will be able to deduct your contributions no matter how much income you earn. On the other hand, if you do have an employer-sponsored plan, you may have to pay taxes on your contributions if your income is too high.
Does it ever make sense to have a traditional IRA if you can’t deduct the dollars you put in? In short, yes. But there may be better options for you.
One of these options is a Roth IRA. A Roth IRA is an individual retirement account in which you cannot deduct your contributions from your taxes. However, you are free to withdraw this money tax-free in your retirement. Roth IRAs can be a great alternative for many people who expect to be in a higher tax bracket later.
Additionally, if you don’t receive the full tax benefits of a traditional IRA, it may make more sense to simply contribute as much as you can to your 401(k) or other work-sponsored plan and max those contributions out.
How Do These Accounts Work?
You can open a traditional IRA through a traditional brokerage or mutual fund like Fidelity, your bank, your financial advisor or even through a robo-advisor such as Betterment. Different brokerages and banks may have access to different securities and funds in which you can invest.
Whether it makes sense to open your account with a traditional money manager or through a robo-advsior will depend on how active a role you want to play in managing your money.
Once you fund your account, you can start contributing income with pre-tax dollars. Then, you either actively pick your investments like stocks, bonds and mutual funds, or, if you’ve gone with a robo-advisor, they are chosen for you based on certain dimensions. Your investments are able to grow with the taxes deferred until retirement.
The more you contribute to your retirement accounts now, the more time they will have to compound and grow through the years. This will set you up well for a happy and healthy (and wealthy) retirement. To see how big you portfolio can grow, check out this free investment calculator.
And finally, when you reach retirement age, you can begin to withdraw the money from your traditional IRA to fund your golden years. You can combine these disbursements with payments from social security, your 401(k) and other accounts to fully fund your retirement.
Withdrawing Funds From Your Traditional IRA
When you reach the age of 59 1/2, you can begin withdrawing retirement funds from your traditional IRA without paying taxes. Withdrawing any time prior to this age, with certain exceptions, will subject you to both taxes and a 10% withdrawal penalty.
When you withdraw funds from your IRA during your retirement, you will be taxed on these funds. But because you were not initially taxed when you contributed your funds and they can grow tax-deferred, you have likely still reaped significant tax advantages.
But you don’t have to take your distributions once you hit age 59 1/2. In fact, it may be of great benefit to let these investments keep growing tax-deferred for as long as possible. This allows them to have more time in the market and to keep compounding.
However, by the time you are either 70 1/2 or 72 (depending on when your birthday falls), you must begin taking withdrawals from your traditional IRA account to fund your retirement years.
While it is also possible to withdraw your money before age 59 1/2, the 10% penalty for doing so is steep. While it may make sense to do so if you are in a financial crisis, most of the time it is best to leave your traditional IRA alone until at least age 59 1/2.
Concluding Thoughts on the Traditional IRA
A traditional IRA can be a great way to save for retirement. The main benefits are that you can contribute to it with pre-tax dollars and let those investments grow tax-deferred.
Of course, there are other types of accounts you can use to save for retirement as well. These include 401(k)s, Roth IRAs, spousal IRAs and more. Each person’s retirement planning scenario is different, so one or more of these types of accounts may be the best fit for you.
If you are interested in learning more about how to invest for retirement, I highly recommend that you sign up for the Wealthy Retirement e-letter by submitting your email in the subscription box provided.
There is no better time to start saving for retirement than the present, and funding a traditional IRA is one of the best ways to begin doing so. Your retired self will thank you for it later.
About Brian M. Reiser
Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.
He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.
His primary interests at Investment U include personal finance, debt, tech stocks and more.