Traditional IRA (individual retirement account) are retirement plans where individuals can contribute pre-tax income. Savings inside of a traditional IRA grow tax-deferred until you begin withdrawing funds.
These plans offer tax deduction advantages as well. Contributions can be deducted from your annual tax bill as long as you qualify. Qualified deductions are based on your modified adjusted gross income (MAGI). Before we dive into the details, let’s make sure this retirement plan works for you.
Who Should Open a Traditional IRA?
Saving for retirement is not easy because there are so many plans to choose from. The most common include traditional and Roth 401(k) plans, traditional and Roth IRA, and 403(b) plans. It’s important to understand that 401(k) and 403(b) accounts are employer-sponsored (with the exception of one-participant 401(k) plan), meaning you must work with your employer to open one. Note, that your annual contribution for IRAs, $6,000, are much less than 401(k) plans, $19,500.
Another drawback of using an employer-sponsored retirement plan is that you limit your choices to whatever your company chose – this could mean less investment choices and higher fees. If you prefer to have more flexibility in managing your investments, an IRA is a great plan to use.
How To Open a Traditional IRA
Opening an IRA account is as easy as opening a brokerage account, literally. In the last two years, personal investing has grown wildly popular across all ages, and thanks to a few distributors in the market, most brokerages offer commission-free trades – for context, just three years ago it was a big deal when Fidelity’s commissions were dropped from $7.95 to $4.95.
Opening a Traditional IRA with a Broker
Opening a traditional IRA is fairly straightforward. Here are the three steps to take in order to open one.
Step 1: Define what type of investor you are
Robo-advisors apps, such as Betterment or M1 Finance, have gained tons of traction by managing and/or preparing pre-existing portfolios for investors of all ages to choose from, and contribute to.
If you want to have a human helping you with your investment, I would recommend seeing a financial advisor.
Either way, if you are new to investing, and want to be shown the ropes before doing it on your own, these are great choices.
On the other side, managing your own IRA can be tough, but also be very rewarding. You are responsible for creating your own portfolio by researching, and choosing from individual stocks, bonds, ETFs or mutual funds that are consistent with your risk comfortability.
If this route attracts you, you’re probably a more hand-on investor, and are better off opening an IRA through a brokerage like TD Ameritrade, or Charles Schwab.
Step 2: Set up your account
Once you’ve decided which type of investor you are, it’s time to open an account. No matter what route you take, you’re going to have to provide personal information (i.e. name, address, SSN, etc.) to open an account.
IMPORTANT: Be sure when you choose what type of account you want, choose traditional IRA. Don’t be like me and completely set up a Roth IRA, when you’re looking for a traditional IRA!
Step 3: Contributing to your plan
Once you’ve completely set up your brokerage account, and started a traditional IRA plan, you can begin contributing, and watching your money grow!
Contributing to a Traditional IRA
Both traditional and Roth IRA plans have a max annual contribution limit of $6,000. People over the age of 50 are eligible for “catch-up contribution,” which is an additional $1,000. Contrary to Roth IRAs, where you cannot contribute after a particular MAGI (for a single head of household in 2020, that is $139,000), there is no MAGI cap for traditional IRAs. Although, you may not qualify for tax deductions after a certain MAGI.
Tax Deductions for Traditional IRA
|Filing Status||2020 MAGI||Deduction Amount|
|Single/head of household||<$65,000||Full|
|$65,001 – $74,999||Partial|
|Married filing jointly||<$104,000||Full|
|$104,001 – $123,999||Partial|
|Married filing jointly (spouse has plan covered by work)||<$65,000||Full|
|$65,001 – $74,999||Partial|
|Married filing separately (you or spouse has plan covered by work)||<$10,000||Partial|
Traditional IRA and Taxes
The tax benefit with Traditional IRAs comes upfront, meaning you may qualify to deduct contributions from your current year’s tax bill. Since the contributions are pre-tax, you will be responsible for paying taxes on the savings when you begin withdrawing funds. This is similar tax treatment to traditional 401(k) plans.
Contributions to Roth IRA and 401(k) plans are taxed upfront, and grow tax free. These are great choices for those who believe they will be in a higher tax bracket when you begin withdrawing money.
Traditional IRA vs Roth IRA Age Limits
Thanks to the changes in the SECURE Act of 2019, there are no longer age limits for either Traditional or Roth IRA accounts as of the first day of 2020. For both Traditional and Roth IRA, the following hold true:
- No age limit to open a Traditional IRA or Roth IRA
- There is not an age limit to who can contribute to either IRA plan (before 2020, individuals over 70 ½ could not contribute)
- Savings cannot be withdrawn from a IRA until age 59.5 (If so, there is a 10% penalty fee and income tax added to the amount withdrawn)
Traditional IRAs have required minimum distributions (RMDs) rules which state:
- RMDs must begin by April 1st in the year at which you turn age 72 (new to 2020)
Withdrawing From a Traditional IRA
The general rule with all retirement plans is to not touch the money until you hit 59 ½. Early withdrawal from your IRA savings will be taxed at your income rate + another 10% penalty for not following the rules. That said, the IRS recognizes that life events happen, and you may need to access emergency funds. Check out a list of events that you can avoid the 10% penalty tax on below:
- Turn 59 ½ (distributions are required by 70 ½)
- Medical expenses that are NOT covered by insurance and are +10% if your MAGI
- Help pay for college expenses (e.g. tuition, fees, books, supplies, etc.)
- $10,000 per individual can be withdrawn for a first home purchases
- Disability payments for those who cannot work (individuals must get a physician to sign off on their condition)
- Active military members of more than 179 days do not pay the penalty
- To see the IRS’s full list of exceptions, please see here
Traditional IRAs also have RMDs (required minimum distributions) that must begin April 1st of the year you turn 72. If you do not begin RMDs then, you will be hit with a 50% tax penalty, as well as the additional taxes owed. Long story short, follow the rules!
Final Thoughts: Is a Traditional IRA for You?
When choosing a retirement plan, there is no right or wrong way, it comes down to what you qualify for, and how well you take advantage of those benefits. To summarize the key benefits of a Traditional IRA, it comes down to:
- Flexibility: unlike 401(k) retirement plans, traditional IRAs are created by you, which means you are responsible for managing and choosing your own investments without limitations to what your employer has available to you.
- Deductions: since contributions to traditional IRAs are pre-tax, depending on your MAGI, you may qualify for deductions on your contribution year’s tax bill.
If you’re considering looking for help in starting your retirement plan, you’re not alone – that’s why we created the financial advisor matching tool to help you find qualified representatives in your area to help you meet your financial goals.