What Is a Traditional IRA?
A traditional individual retirement account (IRA) is a type of investment vehicle that provides tax benefits to help you better save for retirement. Essentially, traditional IRAs offer the potential for upfront tax deductions on contributions at the time they are made and tax-deferred growth of that money later on. At a high level, the process works as follows:
- Qualifying contributions are made on a pre-tax basis, providing tax deductions that lower your tax obligation in the year that they are made.
- Your contributions are invested and allowed to grow free of tax, which can have a powerful compounding effect over the long term.
- Income taxes are only paid when the funds are withdrawn. At this stage, withdrawals are taxed at your current income tax rate, which can be lower than the income tax rate that applied during your working years.
How Do You Open a Traditional IRA?
You can open a traditional IRA through a brokerage firm, such as Charles Schwab, E-Trade or Fidelity Investments, or through a banking institution. Generally, you will have a broader range of investment options with a brokerage firm. Bank offerings are often limited to certificates of deposit and other savings accounts.
If you work with a financial advisor, they can help guide you through the process. In most cases, the process will involve leveraging the brokerage and banking framework you already have.
Traditional IRA Eligibility
Per the Internal Revenue Service (IRS), anyone with earned income can open and contribute to a traditional IRA and reap the benefits of tax-deferred growth. However, as outlined in the two statements below, not everyone is eligible to deduct the contributions they make to an IRA on their annual tax return.
- If you or your spouse participate in a workplace retirement plan, the tax deductibility of your contributions is reduced or eliminated as your income grows.
- If you or your spouse do not participate in a workplace retirement plan, you can fully deduct your contributions, regardless of your income.
If you participate in a workplace retirement plan, the tax deductibility of your contributions is reduced by an amount based on your modified adjusted gross income (MAGI), which takes your adjusted gross income and adds back in a handful of exclusions and deductions, such as tax-exempt interest income and student loan interest you pay. For the 2021 tax year, the deduction limits set by the IRS for single filers can be summarized as follows:
A full IRA deduction on your contributions is available when your MAGI is $66,000 or less. A partial deduction is available when your MAGI is between $66,000 and $76,000. If your MAGI is $76,000 or above, no deduction is permitted.
Similar limitations apply to married filers, but the MAGI levels depend on whether you’re filing jointly or separately, and whether you or your spouse participates in a workplace retirement plan. For detailed information, please refer to the IRS rules for 2021 IRA Deduction Limits.
How Do Traditional IRAs Work?
For 2023, the annual contribution limit to IRAs is $6,500 for people under age 50 and $7,500 for people aged 50 and over. It’s important to note that this is an aggregate limit that applies to all IRAs you own, including traditional IRAs and Roth IRAs. You can continue to make regular contributions to a traditional IRA at any age, but all of your contributions must come from earned income.
Aside from making annual contributions, you can add to a traditional IRA by rolling over funds from another retirement account, such as a 401(k) plan. That said, certain rollovers can trigger tax liabilities. Before making any rollover contributions, be sure to fully assess the ramifications.
For traditional IRAs, the distributions you take will be taxed at your income tax rate at the time the withdrawal is made. If the distributions are taken prior to age 59 ½, a 10% federal tax penalty applies. However, in certain situations you may be permitted to take early withdrawals from an IRA without a 10% penalty. Expenses that may exempt you from the penalty include, but are not limited to, the first-time purchase of a home, medical bills and higher education payments.
The IRS requires you to begin taking distributions no later than April 1 of the calendar year following the year you turn 72. If you turn 72 in 2023, your first required minimum distribution won’t be until April 1, 2025 at 73 years old, thanks to the SECURE 2.0 Act. These rules are known as RMDs.
What Are Your Investment Options?
Traditional IRAs can hold a wide variety of asset types, including cash, stocks, bonds, alternative investments and fund-style vehicles consisting of various combinations of assets. As a result of this flexibility, you can set up an IRA to achieve virtually any risk-return profile you desire.
The flexibility of an IRA does not mean that every type of investment is permitted. The IRS specifically prohibits IRAs from holding life insurance contracts, collectibles and certain derivative instruments. Further, if you want to hold gold or cryptocurrency, you will have to open an IRA that is specifically designed to house those assets.
When making any type of investment, you need to carefully consider your unique circumstances and your tolerance for risk. Your tolerance for risk is largely determined by your time horizon, or the amount of time you have to reach a certain financial goal.
If you plan on working for at least another seven to 10 years, your investing horizon is relatively long. You can withstand the ups and downs of the market because you have no intention of touching the money anytime soon. Accordingly, you are able to assume a higher degree of risk than someone who is on the verge of retirement.
With a long time horizon, it’s wise to consider investing in more growth-oriented stocks (perhaps, 50%). The remainder of your portfolio could consist of value-oriented, dividend stocks (perhaps, 30%) and a sleeve of diversified bonds (perhaps, 20%). Over time and as you transition toward retirement, these allocations should shift, bringing you toward a more traditionally conservative allocation of 60% stocks and 40% bonds.*
*The allocation percentages provided are reasonable for many investors, but purely hypothetical. The optimal allocation is dependent on a personalized assessment, which is most effectively handled by a knowledgeable financial professional.
Low Maintenance Options
Investing in a traditional IRA does not have to be an overly complicated process. In fact, with some basic knowledge and guidance, the investment plan outlined earlier could be achieved in a low-cost, passively managed way using a few index mutual funds or exchange-traded funds.
These fund-style vehicles, which are offered by some of the largest, most reputable investment companies, offer highly diversified exposure to just about any asset or group of assets. Index funds and exchange-traded funds are economical, highly liquid and fairly easy to understand because they track well-known indices, such as the Standard & Poor’s 500 index, also known as the S&P 500 Index, and the Bloomberg U.S. Aggregate Bond Index.
If you wish to be a truly hands-off investor, a growing number of “target date funds” can make the process even easier. These instruments give you the ability to select a custom fund based on your planned retirement date. Once selected, the administration of your investments becomes automatic, as the appropriate mix of stocks, bonds and other investments is dynamically adjusted as you age.
Traditional IRAs: Pros vs. Cons
Traditional IRAs have more advantages than disadvantages. Moreover, the disadvantages can be largely avoided through careful planning and fiscal discipline. The pros and cons provided below illustrate the primary things you should consider.
Pros & Cons
- No income limits to open and contribute to a traditional IRA
- Eligible tax deductions for contributions can be claimed whether or not you itemize deductions
- Auto contributions can facilitate disciplined savings for individuals inclined to spend
- Can house a wide variety of diverse assets, including stocks, bonds, alternative investments and cash
- Can be implemented in a low-cost, passive manner with minimal hands-on effort
- Tax-deferral allows for the powerful effect of enhanced compound growth of investments
- Savings can be used for certain purposes without incurring an early distribution penalty
- Annual contributions are limited to only $6,500 for individuals ($7,500, if age 50 or older)
- If covered by a workplace retirement plan, tax deductibility is reduced/eliminated at higher incomes
- Generally, a 10% penalty applies for distributions taken prior to age 59 1/2
- Generally, IRS requires distributions to begin by age 72 (70 1/2, if you reach age 70 1/2 before January 1, 2020)
- Can create tax risk due to exposure to increases in income tax rates at the state and federal level
Traditional IRA and Roth IRA Structures
In addition to the traditional structure, IRAs are available in a Roth structure. As discussed previously, with a traditional IRA, your contributions are generally tax-deductible in the year in which they are made. The contributions are invested and grow during your working years. Later, in retirement, the withdrawals are taxed at your current income tax rate.
Conversely, with a Roth IRA structure, there is no upfront tax deduction on the contributions you make. The contributions are invested and grow during your working years, which is similar to a traditional IRA. In retirement, all withdrawals from a Roth IRA are free from taxation. For more information, see Roth IRA.
Which Is Better?
When deciding whether it makes more sense to invest in a traditional IRA or a Roth IRA, the most important consideration is whether you expect to be in a higher tax bracket during your working years or during your retirement. A traditional IRA works best if you expect to be in a higher bracket during your working years; conversely, a Roth IRA works best if you expect to be in a higher bracket during your retirement years.
Unfortunately, given the highly unpredictable nature of economic cycles, geopolitical events and tax legislation, projecting your future tax rate is nearly impossible. With this in mind, it is recommended to assign a portion of your retirement savings to traditional-style vehicles and a portion to Roth-style vehicles.
Having a mix of investment types is fairly easy to manage and will enable you to maintain flexibility with regard to taking future income distributions in a tax-efficient manner. In years that you don’t have as much income, it is wise to prioritize making withdrawals from your traditional account because this money has never been taxed. In high-income years, it’s smart to withdraw from your Roth account because the withdrawals are tax-exempt.