What is a Traditional IRA and How Does It Work?

A Traditional IRA, or individual retirement account, is a type of investing account that is designed to help you save for retirement. The account allows you to defer paying taxes on investment gains until retirement, and the contributions you make today can potentially be tax deductible.

You can open a Traditional IRA through a variety of financial institutions such as online brokers and robo advisors. Simply fill out an online application by providing the necessary information. Once your account is approved, you can transfer funds from your bank account and use that money to buy investments through your Traditional IRA.

Traditional IRAs offer what is called a tax deferred benefit. In other words, you get to defer or wait to pay taxes on the money you earn from investments within the account until you pull it out in retirement. For example, let's say that you invested in stock index funds through your Traditional IRA.

Lets also assume that your investments were able to provide an average return of 10% per year as you saved for retirement. If you were to hold these investments in a taxable brokerage account, you could potentially owe capital gains tax each year if you decided to cash in and sell your investments for a profit.

With a Traditional IRA, you do not have to pay taxes on any of the gains you earn until you pull the money out in retirement - at which point you would owe taxes. Make sense? In other words, you get to wait to pay taxes on the money you make off of your investments until you retire.

There is a caveat to this benefit, but we will look at that later when we discuss the rules of the account. In addition to the tax deferred benefit, the contributions that you make to a Traditional IRA may also be tax deductible.

For example, let's say that your annual income is $75,000, but you contribute $5,000 per year to a Traditional IRA. This contribution would reduce your taxable income from $75,000 to $70,000. Whether or not contributions are tax deductible depend upon several factors.

1) If you (or your spouse if you are married) do not use or contribute to an employer sponsored retirement plan, such as a 401k, you can typically deduct the full amount of your contributions to a Traditional IRA up to the limit - which we will look at later.

2) If you (or your spouse if you are married) do use or contribute to an employer sponsored retirement plan, the amount of your contributions that you can deduct will vary based upon your tax filing status and income. You may be able to deduct the full amount of your contributions, a partial amount, or no amount at all.

See the chart below to see if you qualify to take a full deduction, partial deduction, or no deduction at all. These rules apply if you contribute to an employer sponsored retirement plan. Accurate as of 2024.

If you are not covered by an employer sponsored retirement plan, but your spouse is, there are some additional deduction rules. Accurate as of 2024.

You can hold most "traditional" investments in a Traditional IRA. This would include assets such as stocks, mutual funds, index funds, ETFs, corporate bonds, and government bonds. Alternative investments such as life insurance contracts and collectibles such as artwork are not allowed to be held in a Traditional IRA.

However, this is not really an issue for most investors who opt to use a Traditional IRA. Since the Traditional IRA is designed for retirement, most investors will hold a mix of traditional assets in the account to lower their exposure to risk and increase the potential for positive returns over the long haul.

A Traditional IRA does not make you money in and of itself. It is the investments that you hold within a Traditional IRA that make you money. With that being said, the tax benefits of a Traditional IRA might be able to help you reduce taxes, or be more tax efficient which can indirectly make you money.

1) Capital gains - A capital gain is simply an increase in value of a capital asset (stocks, investment funds, etc.). For example, if you bought a variety of stocks at an initial total value of $500, but the value then increased to $750 a few years later, you would have a capital gain.

It is important to understand that you cannot cash in on these capital gains during the year that you experienced them due to the rules of a Traditional IRA. Instead, all of these gains compound over time, and you get to cash in on them when you pull the money out of the account in retirement.  

2) Income earned - Certain investments allow you to earn a small stream of income. For example, you could hold bonds that earn interest or stocks that pay dividends within a Traditional IRA. A dividend is simply a portion of a company's profits that is passed onto you for being a shareholder.

Similar to capital gains, you cannot cash in on any income you earn from investments within a Traditional IRA until you retire. All the income that you earn stays within the account and can help compound your money as you save for retirement.

Due to the potential tax benefits that a Traditional IRA can provide, there are several rules that you must follow in order to use the account.

The good news is that anyone who has earned income can open and use a Traditional IRA. The IRS defines earned income as taxable compensation. This would include wages or salaries from an employer. As long as you have this, you can open and use a Traditional IRA.

If you are at least 18 years old, you can open and hold a Traditional IRA in your name. If you are younger than 18 years old, you will need the help of a parent or guardian to open an IRA. For example, a 16 year old that works at a local business can open an IRA and contribute to it with the help of a parent.

Since a Traditional IRA provides tax benefits, the IRS limits the amount of money that you can put into the account per year. For 2024, the most you can contribute to the account is $7,000 per year or $8,000 per year if you are 50 or older.  

Additionally, the maximum amount of contributions that you can deduct per year are tied to the limits above. So, if you are younger than 50 years old and contribute $7,000 in 2024 to a Traditional IRA, the full contribution of $7,000 may be tax deductible if you qualify for a deduction.

Thirdly, Traditional IRAs have rules on when you can withdraw money from the account. The rules are simple. Once you are 59 and a half years old, you can start withdrawing money from a Traditional IRA. If you try to withdraw the money before then, you will incur a 10% penalty as well as any applicable income taxes.

Remember, you deferred your taxes until retirement, so when you take a withdrawal you will be subject to pay income taxes on the amount you withdraw. There are two ways withdrawals are taxed.

1) Tax deductible contributions - If you were able to take a tax deduction on the contributions you put in a Traditional IRA, 100% of your withdrawals are subject to income taxes. Since you got a tax break on the contributions and growth in the account at the time contributions were made, you have to pay taxes on the full amount of your withdrawals.

2) Non-deductible contributions - If you were not able to take a tax deduction on your contributions, only a partial amount of your withdrawals would be subject to taxes. This can seem a little complicated, but let's think through it.

Since you were not able to deduct your contributions when you made them, it means that you contributed to a Traditional IRA with dollars that have already been taxed. The IRS does not tax you again once you pull out these dollars in retirement.

However, all the money you made off of the investments that you bought with your contributions are subject to income tax. Why is this? It is simple. You have not yet paid taxes on the money you earned from investments. Remember, you get to defer the gains with a Traditional IRA.

A ratio is created to track how much of your total account balance is nondeductible contributions. For example, let's say that at retirement, you had a total of $10,000 worth of nondeductible contributions in a Traditional IRA with a total account balance of $100,000.

This means that 10% of your money in the account is made up of dollars that have already been taxed. When you take a distribution 10% of the distribution would not be subject to taxes. So, if you took of withdrawal of $5,000 from your Traditional IRA, 10% of it ($500) would not be subject to taxes, whereas the remaining $4,500 would be subject to taxes.

3) Speak with a CPA - Taxes surrounding Traditional IRA withdrawals can be quite complex. This is especially true for non-deductible contributions as you have to keep track of them via IRS Form 8086. It is a very good idea to speak with an expert, such as a CPA, to help you with these tax implications.  

Finally, Traditional IRAs have what are called required minimum distributions. A required minimum distribution, or RMD, is the minimum amount of money that you must withdraw from the account once you reach a certain age.

In other words, the IRS forces you to pull money out of the account at a certain age. The reason is that they have not been able to tax the dollars in the account and would like the opportunity to do so. Once you are 73 years old, you will be required to take RMDs from a Traditional IRA.

Your RMD is typically calculated by taking the outstanding balance in your account from the previous year and dividing it by your remaining life expectancy. It is important to make sure you follow these rules as you can incur a 25% penalty for missing the required minimum distribution.

1) Tax advantages - The obvious advantage of a Traditional IRA are the tax benefits. It is possible to reduce taxes today by making tax deductible contributions, as well as deferring the taxes you owe on the gains within the account until you retire. Depending upon your current tax rate and your retirement tax rate, it can make sense to take advantages of these tax benefits.

2) Eligible for anyone with earned income - As long as you have earned income, you can open and use a Traditional IRA. This would include both adults, as well as minors as long as they have the help of a parent or guardian.

3) Large selection of investments - There are certain investments that are not allowed in a Traditional IRA, but if you are an every day investor, you will have plenty of investment options. You can invest in both government and corporate bonds, individual stocks, and investment funds.  

1) Lack of flexibility - The main disadvantage of using a Traditional IRA is that you do not have that much control over the account in several areas. You are limited on the amount of money that you can put it, and can't access that money until you reach a certain age - unless you want to pay a 10% penalty.

Additionally, you will be required to pull money out at a certain point even if you do not want to. Now, these disadvantages do not mean that the Traditional IRA is bad. Since the account is designed for retirement, it might not bother you that you cannot access the money until you retire or have to take RMDs at age 73.

2) Risk of rising taxes - A secondary disadvantage of a Traditional IRA is the risk of rising taxes. If taxes rise significantly during the years of your retirement, using a Traditional IRA would be a bad call. Essentially, you would have waited to pay taxes until they increased - who wants to do that?

In this scenario, it would be better if you already paid the taxes when you put the money into the account, and did not have to worry about taxes when you retired. This is exactly where a Roth IRA can come into play. You can learn more about that account below.  

If you are considering using a Traditional IRA, you should contrast it with a Roth IRA. A Roth IRA is another type of retirement account and works in the opposite way of a Traditional IRA. With a Roth IRA, the money you contribute grows tax free and you do not have to pay taxes once you pull the money out in retirement.

Unlike a Traditional IRA, contributions to a Roth IRA are not tax deductible. Instead, you pay taxes on the dollars you contribute today, and get tax free withdrawals in retirement. So, you either take a tax break today, or you get a tax break when you retire.

Which one should you choose? Well, like most things in personal finance, it depends. The typical advice you will hear is that you should choose a Traditional IRA if you expect taxes to be lower in the future, and a Roth IRA if you expect to be higher in the future.

If taxes are lower in the future, you want to defer paying taxes until then so you owe less in taxes. If taxes are higher in the future, you want to pay taxes now, so you don't owe more later on. With that being said, it usually is not that simple.

When choosing between a tax deferred (Traditional) or tax free (Roth) IRA, you are trying to predict what your taxes will be like in the future, which is quite challenging to do. In some cases, it might make sense to use only a Traditional, only a Roth, or a mix of the two.  

If you need help deciding between the two, you can speak with a tax professional such as a CPA or a licensed financial advisor to help you make a more informed decision.

The bottom line is that a Traditional IRA is an investing account designed to help you save for retirement. The account allows you to potentially have a tax deduction today, while also deferring the taxes on the gains of the investments within the account until you retire.

You can hold most traditional assets within the account including stocks, bonds, and investment funds. There are a variety of rules that you have to follow while using the account including contribution limits, withdrawal rules, and RMDs.

A Traditional IRA might be a good option if you are looking to reduce taxes today and expect to be in a significantly lower tax bracket in the future. Deciding if a Traditional IRA is right for you can be tricky as you need to consider a multitude of variables. Speaking with a financial professional such as a CPA or financial advisor can help you make a more informed decision.