What is a Traditional IRA? Definition & How They Work

Investing
Updated: 6th Jan 2021
Written by Kim Pinnelli
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When you think about retirement savings, you likely think of the traditional IRA. It’s the account you can write off at tax time and the one that you pay taxes on when you withdraw during retirement.

Just because it’s the most common doesn’t mean it’s the right one for you, though. Learn the pros and cons of the traditional IRA and its alternatives so you can choose what’s right for you.

What is a Traditional IRA?

A traditional IRA is a individual retirement account wage earners can set up to invest pre-tax income into their retirement. You don’t owe taxes on the money (including earnings) until you withdraw it during retirement.

How Does a Traditional IRA Work?

You can open a traditional IRA at a bank or with an online stock broker. You make contributions anytime throughout the year. You get the tax break on the contributions in the tax year that you contribute them.

Your contributions grow tax-deferred. When you withdraw the funds in retirement, you pay the applicable taxes according to your current tax bracket. If you withdraw funds before age 59 ½, though, you’ll pay the taxes plus a 10% penalty.

You may invest your funds in conservative banking products, such as a certificate of deposit or high-yield savings.

If you want something a bit more aggressive, you can open an IRA at a brokerage firm and invest in exchange-traded funds, stocks, bonds, or mutual funds.

Who is Eligible for a Traditional IRA?

Anyone under the age of 70 ½ with taxable income may contribute to a traditional IRA.

But if you work and have an employer-sponsored 401K, you may be limited based on your income level and tax filing status:

  • Single filers making $66,000 – $76,000
  • Married filing joint filers making $105,000 – $125,000 if the spouse making contributions has a 401K plan
  • Married filing joint filers making $198,000 – $208,000 if the spouse making the contributions aren’t covered by a 401K plan

What is the Benefit of a Traditional IRA?

Bottom line up front, traditional IRAs allow consumers to save for retirement. It is a flexible investment vehicle that empowers you to invest your money responsibly.

Pros:

  • You don’t have to worry about income limits unless you have a company-sponsored 401K.
  • You defer your tax liabilities on any gains until you withdraw them during retirement.
  • You get tax-sheltered growth, allowing you to reinvest dividends and earnings for even more growth without worrying about taxes until you retire.
  • You may be in a lower tax bracket during retirement, which means paying fewer taxes.
  • You can deduct your IRA contributions in the year you make them.
  • You can use IRA savings to buy your first home or pay for college expenses without paying the penalty.

Cons:

  • There’s a 10% early withdrawal penalty if you withdraw funds before age 59 ½ for any reason except buying your first home or using the money for educational expenses.
  • You may be subject to Required Minimum Distributions if you don’t withdraw funds before age 70 ½.
  • Your tax deductions may be limited if you have a 401K at work.

How Much Can I Contribute to a Traditional IRA?

The traditional IRA contribution limit for 2021 remains the same as in 2020. You can contribute up to $6,000 for the year if you are under age 50.

If you are over 50-years old, you may make catch-up contributions of up to $1,000 for a total of $7,000.

What Are the Tax Advantages of a Traditional IRA?

The traditional IRA offers two tax advantages:

  • Tax deductions – You can deduct your traditional IRA contributions in the year you contribute them. The contributions (up to $6,000) directly reduce your taxable income, lowering your tax liability.
  • Tax-deferred growth – Your earnings grow tax-deferred, which leaves more money to keep growing. Your retirement savings grow faster this way than if you owed taxes on each capital gain as you would in a taxable account.

Who Can Deduct Traditional IRA Contributions from Their Taxes?

Anyone can deduct traditional IRA contributions from their taxes if they don’t have a retirement plan at work (401K).

Higher-earning individuals and couples who have a 401K at work may be limited in the amount of IRA contributions and can deduct on their taxes. If you earn too much, you may not deduct your contributions at all.

Traditional IRA Withdrawal Rules

If you keep your funds in your traditional IRA until at least age 59 ½, you won’t pay any penalties. You’ll just pay taxes on the amount you withdraw.

If you withdraw funds before age 59 ½ and it is not for one of the following reasons, you’ll pay a 10% penalty on top of the taxes owed:

  • Pay for higher education expenses for yourself or a dependent
  • Use up to $10,000 for the purchase of your first home
  • Use up to $5,000 for the birth or adoption of a child
  • Cover unreimbursed medical expenses that are more than 7.5% of your adjusted gross income
  • Withdraw funds to help if you become permanently disabled

Traditional IRA Penalties

The IRS charges a 10% penalty if you withdraw funds before age 59 ½ for any reason other than above. The 10% penalty is in addition to the taxes you’d owe on any money you withdraw.

Do I Need a Traditional IRA?

No one ever has too much money for retirement. Even if you can’t deduct the contributions, there’s a benefit to the tax-deferred status of your earnings.

You can save for retirement and defer the tax liabilities to when you withdraw the funds in retirement. If you are in a lower tax bracket during retirement – you come out ahead.

What is a Nondeductible Traditional IRA?

If you make too much money or you’ve maxed out your deductible contributions, you can still contribute to a nondeductible traditional IRA. The only difference with this retirement account is you can’t write off the contributions.

But you still get the tax benefits, which is often the largest benefit since you can let your money grow without paying taxes. Your retirement income will grow faster in this account than it would in a taxable account.

Can You Lose Money in a Traditional IRA?

Depending on how you invest your traditional IRA funds, you can lose money. No one can predict how the market will react or what investments will do well.

If you invest for the long haul, though, you should come out with a decent return. Think about your risk tolerance and timeline when you create your portfolio.

As is the case with any investment, diversify your portfolio, so you offset the risky investments with more conservative investments for the greatest outcome.

How Much Money Do You Need to Start a Traditional IRA?

Many brokers have a $0 minimum for their traditional IRA accounts. Of course, you’ll need to add money to save for retirement, but knowing that there’s no minimum balance requirement is a great way to get started.

You can then make contributions as you can, even if they are small. Every dollar helps.

Alternatives to a Traditional IRA:

  • Roth IRA: If you think you’ll be in a higher tax bracket in retirement than you are now, a Roth IRA may make more sense. A Roth IRA doesn’t provide the tax deduction now (when you contribute). Instead, you contribute after-tax dollars, but your money and earnings grow tax-free. When you withdraw funds in retirement, you pay no taxes. Roth IRAs have income restrictions, though, so not everyone will be eligible.
  • Employee Sponsored 401(k): Some employers offer a retirement plan called a 401K. It works just like an IRA, except the contribution limits are much higher. In 2021, you may contribute $19,500 in your 401K. Many employers also match a portion of your contributions, usually between 3% – 5% of your salary. If you have an employer-sponsored 401K, your IRA contributions may be limited depending on your income.

Learn More: Differences Between Roth IRAs and Traditional IRAs

Bottom Line: What is a Traditional IRA?

A traditional IRA is a perfect way to start saving for retirement if you don’t have an employer-sponsored 401K or even if you do and have more money to invest.

If you need the tax write-offs now or you think you’ll be in a lower tax bracket when you retire, the traditional IRA is a great way to supplement your retirement income.

Kim Pinnelli
Kim Pinnelli
Kim is a personal finance expert with a Bachelor’s degree in Finance from the University of Illinois at Chicago. She has been freelance writing for 13 years for a number of large publications. Kim thoroughly enjoys helping people take charge of their personal finances.