Understanding a Traditional IRA vs. Other Retirement Accounts

What Is a Traditional IRA?

A traditional individual retirement account (IRA) allows individuals to direct pre-tax income toward investments that can grow tax-deferred. The IRS assesses no capital gains or dividend income taxes until the beneficiary makes a withdrawal. Individual taxpayers can contribute from qualified earned compensation.

Income thresholds may also apply. Contributions to a traditional IRA may be tax-deductible depending on the taxpayer's income, tax-filing status, and other factors. Retirement savers may open a traditional IRA through their broker (including online brokers or robo-advisors) or financial advisor.

Key Takeaways

  • Traditional IRAs allow individuals to contribute pre-tax dollars to a retirement account where investments grow tax-deferred until withdrawal during retirement.
  • Withdrawals are taxed at the IRA owner's current income tax rate upon retirement.
  • Account holders should adhere to annual contribution limits and be aware of the schedules for required minimum distributions.
  • Nonqualified withdrawals from a traditional IRA are subject to income tax in addition to a 10% penalty before the age of 59½ years old.
  • Unlike Roth IRA contributions, traditional IRA contributions are deductible from your current taxable income.

How Traditional IRAs Work

Traditional IRAs let individuals contribute pre-tax dollars to a retirement investment account, which can grow tax-deferred until retirement withdrawals occur (at age 59½ or later). Custodians, including commercial banks and retail brokers, hold traditional IRAs and place the invested funds into different investment vehicles according to the account holder’s instruction and based on the offerings available.

Contributions to traditional IRAs are tax-deductible in most cases. For instance, if someone contributes $6,000 to their IRA, they can claim that amount as a deduction on their income tax return and the Internal Revenue Service (IRS) will not apply income tax to those earnings. But when that individual withdraws money from the account during retirement, earnings are taxed at their ordinary income tax rate.

The IRS restricts contributions to a traditional IRA each year, depending on the account holder's age. The contribution limit for the 2023 tax year is $6,500 for savers under 50 years of age and $7,000 in 2024. For people aged 50 and above, higher annual contribution limits apply via a catch-up contribution provision, allowing for an additional $1,000. This means it's a total of $7,500 in 2023 and $8,000 in 2024.

Under the SECURE Act of 2019, age restrictions on contributions to a traditional IRA were lifted. As long as the account holder has earned income to qualify, they are eligible to contribute to a traditional IRA regardless of age.

Traditional IRAs and 401(k)s or Other Employer Plans

When you have both a traditional IRA and an employer-sponsored retirement plan, the IRS may limit the amount of your traditional IRA contributions that you can deduct from your taxes.

If a taxpayer participates in an employer-sponsored program such as a 401(k) or pension program and files as a single person, they would only be eligible to take the full deduction on a traditional IRA if their modified adjusted gross income (MAGI) was $73,000 or less for 2023. That amount increases to $77,000 for 2024. Married taxpayers filing a joint return are subject to limits of $116,000 or less for 2023 and $123,000 for the 2024 tax year.

With MAGIs of $83,000 for singles in 2023 ($87,000 for 2024) and $136,000 for married couples in 2023 ($143,000 for 2024), the IRS allows no deductions. The deduction is phased out should the filer's income fall between the minimum and maximum levels.

IRA contributions must also be made by the tax filing deadline. For most taxpayers, this is on or around April 15 of each year.

Income tax is ultimately paid on IRA money at the time of withdrawal, subject to one's tax bracket during retirement. Therefore, traditional IRAs are more often recommended for investors who expect to be in lower tax brackets at retirement than they are currently in.

Traditional IRA Distributions

When you receive distributions from a traditional IRA, the IRS treats the money as ordinary income and subjects it to income tax. Account-holders can take distributions as early as age 59½.

The age for required minimum distributions (RMDs) from traditional IRAs depends on your age and when you were born. You must begin taking distributions by April 1 the year after you turn:

  • 73 if you turn age 72 on or after Jan. 1, 2023
  • 72 if you turn 70½ between Jan. 1, 2020, and Dec. 31, 2022
  • 70½ if you turned that age on or before Dec. 31, 2019

Funds that are withdrawn before age 59½ incur a 10% penalty (of the amount withdrawn) and taxes, at standard income tax rates. There are exceptions to these penalties for certain situations. These include the following:

  • You plan to use the distribution towards the purchase or rebuilding of a first home for yourself or a qualified family member (limited to $10,000 per lifetime)
  • You become disabled before the distribution occurs
  • Your beneficiary receives the assets after your death
  • You use the assets for unreimbursed medical expenses
  • Your distribution is part of a substantially equal periodic payment (SEPP) program
  • You use the assets for higher education expenses or expenses incurred for having or adopting a child
  • You use the assets to pay for medical insurance after you lose your job
  • The assets are distributed as a result of an IRS levy
  • The amount distributed is a return of nondeductible contributions and attributable income
  • You are a military reservist and called to active duty for more than 179 days

An individual needs to check with a tax attorney or the IRS to be sure that the particulars of their situation qualify for a waiver of the 10% penalty.

Traditional IRAs vs. Other IRA Types

Other variations of the IRA include the Roth IRA, SIMPLE IRA, and SEP-IRA. The last two are employer-generated, but individuals can set up a Roth IRA if they meet the income limitations. These individual accounts can be created through a broker. You can check out some of the best options with Investopedia's list of the best brokers for IRAs.

Roth IRAs

Unlike a traditional IRA, Roth IRA contributions are not tax-deductible, and qualified distributions are tax-free. This means you contribute to a Roth IRA using after-tax dollars, but as the account grows, you do not face any taxes on investment gains. Because you paid taxes on your contributions, you can actually withdraw them, penalty-free, at any time; however, you cannot withdraw earnings until age 59½ without being subject to the 10% early-withdrawal penalty.

When you reach age 59½, you can withdraw from the account without incurring any income taxes on your withdrawals. Roth IRAs do not have RMDs. If you don't need the money, you don't have to take it out of your account and worry about penalties for failing to do so. You can also pass the money to your heirs if you don't end up needing to use it.

Roth IRA contributions are the same as traditional IRAs: $6,500 unless you are 50 or older and can qualify for the catch-up contribution, which raises the limit to $7,500 in 2023; $7,000, and $8,000, respectively, in 2024. The catch is that not everyone qualifies to contribute to a Roth IRA. There are income limitations, with contributions gradually phased out as your MAGI increases.

Income Phase-Out Ranges for Roth Contributions
Filing Status  2023  2024
Single $138,000 to $153,000 $146,000 to $161,000
Heads of household $138,000 to $153,000 $146,000 to $161,000
Married filing jointly  $218,000 to $228,000  $230,000 to $240,000

If you earn above those amounts, you can't contribute to a Roth at all.

SIMPLE and SEP-IRAs

SIMPLE IRAs and SEP-IRAs are benefit plans instituted by an employer so individuals cannot open them, although self-employed or sole proprietors may. Generally, these IRAs function similarly to traditional IRAs, but they have higher contribution limits and may allow for company matching.

A simplified employee pension (SEP or SEP-IRA) is a retirement plan that an employer or self-employed individual can establish. The employer is allowed a tax deduction for contributions made to the SEP plan and makes contributions to each eligible employee's SEP-IRA on a discretionary basis. Fundamentally, a SEP-IRA can be considered a traditional IRA with the ability to receive employer contributions. One major benefit it offers employees is those employer contributions are vested immediately.

A SIMPLE IRA is a retirement savings plan that can be used by most small businesses with 100 or fewer employees. SIMPLE stands for Savings Incentive Match Plan for Employees. Employers can choose to make a 2% retirement account contribution to all employees or an optional matching contribution of up to 3%.

Employees can contribute a maximum of $15,500 annually in 2023 ($16,000 for 2024); the maximum is increased periodically to account for inflation. Retirement savers age 50 and older may make an additional catch-up contribution of $3,500, bringing their annual maximum to $19,000 in 2023. The catch-up contribution for 2024 is also $3,500, bringing the total contribution amount to $19,500.

Opening a Traditional IRA

You can open a traditional IRA as long as you received taxable compensation during the year you want to contribute or your spouse earned taxable compensation and you will file a joint return. If both you and your spouse have compensation, both parties can open their own traditional IRA.

A variety of organizations, financial institutions, or brokerage firms can assist in setting up a personal traditional IRA. The account is subject to IRS code requirements, and the custodian of your account (often the brokerage firm you choose such as Fidelity or Vanguard) will manage the account requirements on your behalf.

Contributions into a traditional IRA can be made immediately through your account holder in the form of cash, check, or money order. Physical property is not an allowable contribution type. When setting up an account, there is no minimum balance or starting investment required.

What Is the Difference Between a Traditional IRA and a Roth IRA?

The primary difference between a traditional and a Roth IRA is the tax treatment of each account. Traditional IRA contributions are deductible from taxable income when the contributions are made; however, earnings are taxable. Alternatively, Roth contributions are not deductible but can grow tax-free.

In addition, there are differences in the mechanisms of each IRA. Roth IRA contributions can be withdrawn for no penalty, while traditional IRAs cannot. In addition, some Roth earnings may be able to be withdrawn for no penalties for specific uses (i.e. the down payment for one's first home).

What Are the Rules for a Traditional IRA?

There are several rules for a traditional IRA. The maximum contribution amount is set every tax year, and the IRS requires individuals to begin taking money out of their traditional IRA beginning April 1 the year after they turn 73 (on or after Jan. 1, 2023) and 72 (if they reach age 70½ between Jan. 1, 2020, and Dec. 31, 2022).

The traditional IRA is subject to income taxes and a 10% penalty if unqualified withdrawals occur before 59½ years old. Lastly, your annual contribution to a traditional IRA can be at most what you earned in the contribution year.

What Are the Different Types of IRAs?

The two most common types of IRAs are the traditional IRA and Roth IRA. Less popular types of IRAs include SEP IRAs (often best for self-employed or small business owners), SIMPLE IRAs (often best for small companies that still have numerous employees), or self-directed IRAs (often used by experienced investors seeking specific alternative asset investments).

What Are the Disadvantages of Traditional IRAs?

Like other retirement savings vehicles, funds can often not be withdrawn without tax and fine penalties. Therefore, traditional IRAs are very illiquid savings accounts. In addition, traditional IRAs do not grow tax-free; earnings withdrawn before age 59½ are subject to tax.

Does a Traditional IRA Grow Tax-Free?

No, a traditional IRA does not grow tax-free. Contributions into a traditional IRA receive favorable tax treatment and are often deducted from an employee's taxable income. When it is time to withdraw earnings, any growth on the investment is taxable. In the meantime, earnings are tax-deferred. This is the opposite treatment of Roth IRAs where initial investments cannot be deducted from income, but their growth can be withdrawn tax-free at retirement.

The Bottom Line

One of the more common vehicles used for saving for retirement is the traditional IRA. A traditional IRA allows savers to contribute money into a tax-deferred vehicle using pre-tax (deductible) contributions. Although this investment vehicle can't be accessed until 59½ without taxes and penalties, taxes on the growth of your investment are deferred until then.

Article Sources
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