A staple of modern retirement planning, the traditional IRA remains one of the easiest and most widely-adopted tax-sheltered accounts among middle-class Americans.
Whether you’re age 20 or 70, you should understand traditional IRAs, their benefits, their restrictions and downsides, and your eligibility to take advantage of them. But most of all, you should plan how they fit into your own personal retirement strategy.
Consider the next five minutes to be your crash course on traditional IRAs — and how you can use them to save and invest more money while paying less in taxes.
What Is a Traditional IRA?
The individual retirement account or IRA was created as part of the Employee Retirement Income Security Act of 1974. Its creation reflected the larger trend away from employer pensions, as workers started moving around more in their careers and living longer post-retirement.
As part of the seismic changes to how Americans retired, employers started opting for the predictable expenses of defined contribution plans like 401(k)s and 403(b)s. But not all workers received employer retirement benefits, so the federal government created the IRA as a tax-sheltered way for Americans to save for retirement independent of their job.
You can open an IRA through your investment broker, just like a regular, taxable brokerage account. And like other brokerage accounts, you can pick and choose any investments you like: stocks, bonds, ETFs, mutual funds, commodity funds, and whatever else is your heart’s desire. I personally use Charles Schwab for their commission-free trades and easy platform, but other free investment brokers include TD Ameritrade, Ally Invest, and M1 Finance.
The distinguishing feature of traditional IRAs is that you can deduct contributions from your taxable income. If you earn $50,000 one year and contribute $6,000 to your IRA, you only pay income taxes on $44,000.
Traditional IRAs differ from Roth IRAs in this regard. Unlike traditional IRAs, where you get the tax break immediately but pay taxes on withdrawals in retirement, Roth IRAs work in the exact opposite way. You pay taxes on Roth IRA contributions now, but you can withdraw the money tax-free in retirement.
Benefits of a Traditional IRA
Although traditional IRAs do come with restrictions and downsides, the benefits remain compelling. Just make sure you understand them in full before committing your hard-earned money.
Immediate Tax Deduction
As mentioned above, the primary benefit of a traditional IRA is the immediate tax deduction. You can deduct the contribution from your taxable income, reducing your IRS tax bill.
Most states tax your income based on the modified adjusted gross income (MAGI) on your federal income tax return, so in most states contributions to your traditional IRA are also deducted from your state tax return. Not all states operate this way however, so check with your accountant if you don’t know your state’s rules.
The immediate tax savings can compound over time if you invest them. For example, say you contribute $6,000 to your IRA each year for 30 years. Imagine this saved you $1,500 in income taxes each year, and you took that money and invested it separately for an historically average 10% annual return. At the end of those 30 years, you’d have $246,741 in the separate account, accumulated solely from the tax savings and its returns — and that doesn’t include any of the contributions to your IRA.
A final tax-related perk for IRA contributions is that you have until April 15 of the following year to decide whether to contribute funds. If you don’t know whether you’ll end up having funds to contribute in a given year, you can wait and contribute as late as April the following year.
Compatibility with Other Tax-Sheltered Accounts
To begin with, you can contribute to both a traditional and a Roth IRA in the same year, to spread your tax benefits out. Just be aware that the contribution cap — $6,000 in 2020 — applies to both IRA types, so whether you contribute to just one or the other, or you contribute to both, the same total contribution limit applies.
You can also contribute to both an IRA and an employer-sponsored retirement account, assuming you meet the eligibility requirements for each. Different income limits apply to each retirement account type from SIMPLE IRAs to 401(k) and 403(b). But as long as you don’t exceed the limit for each, you can shunt money into multiple retirement accounts.
Full Ownership and Control
Unlike employer-sponsored retirement plans, you hold complete ownership and control of your IRA.
You own an IRA account through your broker, just like your taxable brokerage account. At any time you can log in, buy and sell assets, even close the account and roll the funds over to a different account with a new broker.
With employer-sponsored retirement accounts, you still own the funds inside the account, but you don’t own the account itself. Your employer pays an account administrator to oversee the account, and when you change jobs, you typically empty the account and roll the funds over to your own IRA or to your new employer’s retirement account if available.
Your IRA can stay with you for life, however. I still have the same IRA today that I did 18 years and nine jobs ago.
Bankruptcy and Asset Protection
People who file for bankruptcy protection don’t need to surrender their IRA accounts. All funds held in traditional and Roth IRA accounts remain untouchable to creditors.
Even without filing for bankruptcy, your IRA funds remain protected from most creditors who win a judgment against you. The greatest exception is the IRS itself, which doesn’t play by the same rules as other creditors.
Flexibility to Convert to Roth Accounts Later
Account holders can move funds from their traditional IRA to their Roth IRA at any time, if they want to pay taxes on contributions this year to avoid paying taxes on withdrawals in retirement.
In fact, some investors go so far as to strategically contribute money to a traditional IRA with the plan to convert it to their Roth IRA later. Because there’s no technical income limit on contributing money to a traditional IRA, but there is for Roth IRAs, investors sometimes use traditional IRAs as a “backdoor” method of contributing to their Roth IRA. The rules get very complicated very fast however, so speak with a financial advisor before considering such a strategy.
Multiply Tax Benefits with the Saver’s Credit
Lower earners can not only deduct their contributions to an IRA (or other tax-sheltered retirement account), they also qualify for a special tax credit. Note that tax credits go directly toward your tax bill, rather than simply coming off your taxable income like deductions do.
Called the Saver’s Credit, it allows lower-income workers to reduce their tax bill even further when they save for retirement. Depending on your income, you might qualify for a credit of 10%, 20%, or 50% of the amount you contribute to your IRA.
The income limits are pretty restrictive however. Single filers can claim a tax credit of 50% of your contribution if you earn less than $19,500 in 2020, a 20% credit if you earn between $19,501 and $21,250, and 10% if you earn $21,251 to $32,500. Above $32,500, you don’t qualify.
Married couples filing jointly can take a 50% tax credit if they earn less than $39,000, a 20% credit if they earn $39,001 to $42,500, and a 10% credit if they earn $42,501 to $65,000.
Beyond the income limit, you must also meet the following criteria to qualify for the Saver’s Credit:
- You’re at least 18
- You’re not a full-time student
- No one can claim you as a dependent on their tax return
Pro tip: If you’re investing in either an IRA or a Roth IRA, make sure you sign up for a free Blooom account. They’ll analyze your portfolio to make sure you have the proper diversification and that your asset allocation matches your risk tolerance. They’ll also look to see if you’re paying more than you should in fees.
Traditional IRA Restrictions and Downsides
If traditional IRAs are so wonderful, why don’t people throw more money into them?
In some cases, they can’t. In others, they opt not to, given the restrictions inherent in them. To make an informed decision about whether to invest through a traditional IRA, and how much, first understand the limits and downsides in addition to the benefits.
In 2020, you can contribute up to $6,000 to a traditional IRA. Or, if you split your contributions between traditional and Roth IRAs, the combined total can’t exceed $6,000. If you’re 50 or over, you can contribute an extra $1,000 as a “catch up contribution,” for a total of $7,000.
These contribution limits typically rise every year or two to keep pace with inflation.
Historically, people over age 70 ½ could no longer contribute to a traditional IRA. However that changed with the SECURE Act of 2019, and the age limit no longer applies starting in 2020 (more on the SECURE Act shortly).
But depending on your income, you may not actually be able to deduct your contribution from your taxable income.
Income Limits to Deduct the Contribution
Before getting into the income limits, it’s worth pausing to note that all Americans can contribute to a traditional IRA each year, up to the contribution limit. But above a certain income, the ability to deduct that contribution from your taxable income phases out.
Single taxpayers can deduct the full amount of the contribution if they earn up to $65,000 in 2020. Between $65,000 and $75,000, the deduction phases out, and above an income of $75,000, taxpayers can’t deduct their contribution.
Married taxpayers can deduct their full contribution if they earn less than $104,000. The deduction phases out for couples earning between $104,000 and $124,000, and above $124,000 they can’t deduct any of their contribution.
Required Minimum Distributions
Starting at age 72, Americans with IRAs must start emptying their account.
These mandatory withdrawals from your IRA are called required minimum distributions or RMDs, and they’re based on an actuarial table for your projected life expectancy. The idea is that you empty your IRA by the time you kick the bucket.
Why does the IRS force you to empty your IRA? The better to tax you, my dear. Remember, you dodged the tax bullet each year that you contributed to your IRA, but you have to pay the piper eventually, and in this case that means paying taxes on withdrawals. Uncle Sam wants his due, and he wants it sooner rather than later.
Later, in some cases, means after you die and your heirs inherit your IRA.
Estate Planning Wrinkles
The inheritance rules for traditional IRAs get hairy quickly, so if you have specific questions, definitely speak with a tax lawyer or investment advisor. A quick example: if your heirs owe estate taxes on your IRA balance, they may have to take a distribution from the IRA to cover them. The distribution would itself also be taxed, creating multiple layers of taxes.
Historically, heirs could spread their distributions out over their lifetimes, allowing the IRA to continue compounding and earning to an extent, with only RMDs to diminish them. But the SECURE Act changed that, requiring heirs to empty the entire IRA within 10years of inheriting it.
In some ways, IRAs cause more headaches for your heirs than they’re worth. If you plan to leave part of your estate to charity in your will, consider earmarking your IRA to go to charity, and leaving other less-regulated assets to your children.
Early Withdrawal Penalties
When you contribute money to your IRA, you agree not to touch it until at least age 59 ½. It is a retirement account, after all.
Tap into the account early, and the IRS slaps you with a 10% penalty. Do not pass Go, do not collect $200.
The IRS does allow a few exceptions to this rule, however. First, you can withdraw up to $10,000 to put toward the purchase of your first home. You can also avoid early withdrawal penalties if you use the money for unreimbursed medical expenses that exceed 7.5% of your gross income, and for health insurance premiums while you’re unemployed.
Another exception permits those with a permanent disability to withdraw money to live on, to allow for the possibility that they are forced to retire early. In some cases, you can also withdraw money penalty-free for higher education expenses. But speak with an accountant or other financial advisor before doing so, to understand the requirements and limitations.
Both traditional and Roth IRAs can and should play a central role in retirement planning. Even those pursuing financial independence and early retirement (FIRE) can leverage tax-sheltered retirement accounts to reach their goals faster and retire young.
But neither IRA is without its limitations. So as you create and continually refine your own retirement plan, make sure you understand the strengths and weaknesses of each retirement account, and how it fits into the larger puzzle of your financial independence post-career.
Do you contribute to a traditional IRA each year? Why or why not?