Looking at Traditional IRAs
A Traditional IRA is a tax-deferred personal retirement savings plan. Every time a contribution is made, the owner is eligible for either full or partial tax-deduction. The amount that is deductable depends on the owner's tax filing status, active participant status, and level of income.
- Tax Filing Status refers to a person's marital status when filing annual income taxes. Examples include "single individual," "head of household," and "married but filing separately."
- Active Participant Status refers to the individual's participation in an employer-sponsored savings programs, such as a 401(k).
Who Is Eligible?
Anyone who has earned taxable compensation in the United States and is below age 70 ½ is eligible for a Traditional IRA.
How Does It Work?
Funds placed in a Traditional IRA reduce the owner's adjusted gross income (AGI), or the amount of taxable income the owner reports for the year after all deductions have been applied. This means a nice cut off of the owner's tax bill since they report a smaller taxable income.
Once deposited, Traditional IRA contributions compound tax-free interest until a maximum age of 70 ½, at which time the owner is required to begin making withdrawals. When withdrawals are made, they are subject to normal income taxes.
How Much Can Be Contributed to a Traditional IRA?
For a Traditional IRA, the Internal Revenue Service (IRS) sets a limit to the amount that can be contributed. These limits begin as a base amount, established yearly, which is then adjusted according to the owner's tax-filing status and AGI.
Because contributions to Traditional IRA reduce the amount of the owner's yearly taxes, additional circumstances such as military service can boost the amount the owner can contribute to his or her IRA; however, not all of these additional contributions may be tax deductable.
While the owner of the IRA may be allowed to contribute more than the yearly set amount, it may not reflect a larger tax savings. The IRS provides more specific, free information on contribution limits and deductibility in Publication 590.
What Are the Age Limits?
Traditional IRAs have a required minimum distribution (RMD). A RMD means that the Traditional IRA cannot grow and compound interest indefinitely. Because taxes were not paid fully or at all at the time of contribution, the IRS has established the maximum age of 70 ½ as the point at which IRA owners must begin withdrawing funds. This way, the funds can continue growing into the owner's retirement, and the government can still collect income tax.
It isn't necessary to wait until age 70 ½ to begin withdrawals. But beware: if withdrawals are made before age 59 ½, the money is subject to tax as well as a 10% early distribution penalty. Also, contributions cannot be made to a Traditional IRA after age 59 ½.
Is a Traditional IRA Right for You?
The Traditional IRA may seem heavily restricted, but it also carries key advantages. Here are a few reasons a Traditional IRA is still a great choice:
- Benefit from Tax Deductions. Depending on your lifestyle, saving on your yearly income taxes can mean a big boost to your budget.
- Start Spending Earlier. If you are someone who has big plans to spend their nest egg once they reach retirement, the RMD rule will work well in your favor.
- Take Advantage of Incentives. With smart investing, it's possible for the Traditional IRA to earn far more than it will be required to pay out in taxes later.
- Boost Your Income. If you haven't retired when it's time to start withdrawing, you can still use those extra funds as a well-deserved boost to your income, regardless of any required payments to Uncle Sam.
