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Retirement

What Is A Traditional IRA? (Rules and Tax Benefits)

Overview

  • A traditional IRA is a type of individual retirement account available to anyone with earned income. There are no age or income limits.
  • Contributions to a traditional IRA are made with pre-tax dollars, and you get a tax-deduction each year you contribute. Investments grow tax-deferred until retirement, and you pay regular income taxes when you take qualified distributions at the age of 59½.
  • The contribution limit for a traditional IRA is $6,000 ($7,000 if age 50+) for 2022 and $6,500 ($7,500 if age 50+) for 2023.

What is a traditional IRA?

A traditional IRA is a type of individual retirement account (IRA) where you contribute with pre-tax dollars and get a tax deduction every year you contribute to your account. Your investments grow in your account tax-deferred until retirement. When you take withdrawals at the eligible withdrawal age of 59½, you pay regular income taxes.

How does a traditional IRA work?

A traditional IRA lets you postpone taxes. Contributions you make to your account are deducted from your taxable income for the year.

For example, if you made $60,000 this year and decide to contribute $3,000 to your traditional IRA, this amount gets deducted from your taxable income. You now only pay taxes on $57,000 ($60,000 minus $3,000) worth of income.

Your contributions in your account get invested and grow tax-free until retirement. When you start taking qualified distributions at the age of 59½, any withdrawals you make are taxed as regular income. The amount you have to pay in taxes depends on your tax bracket and tax rates at the time of withdrawal.

Who is eligible for a traditional IRA?

Anyone who earns taxable income is eligible to open and contribute to a traditional IRA. Unlike a Roth IRA, there are no income limits. With a Roth IRA, if your income is too high, then you cannot contribute at all. With a traditional IRA, you can contribute no matter how high or low your income may be.

However, if you also have an employer-sponsored plan, like a 401k, then your tax deductions may get reduced to zero if your modified adjusted gross income (MAGI) is too high. You’ll still be allowed to make contributions, but you just won’t get any tax deductions.

Traditional IRA tax deduction limits for 2022

  • If your MAGI is $68,000 or less, you get get a tax deduction up to the maximum traditional IRA contribution limit of $6,000 ($7,000 if age 50+).
  • If your MAGI is over $68,000 but less than $78,000, you'll get a partial tax deduction.
  • If your MAGI is over $78,000, you get no tax deduction.

Traditional IRA tax deduction limits for 2023

  • If your MAGI is $73,000 or less, you get get a tax deduction up to the maximum traditional IRA contribution limit of $6,500 ($7,500 if age 50+).
  • If your MAGI is over $73,000 but less than $83,000, you'll get a partial tax deduction.
  • If your MAGI is over $83,000, you get no tax deduction.

This only applies if you also have a day job where you also contribute to an employer-sponsored retirement plan. You can calculate your modified adjusted gross income (MAGI) using Worksheet 1-1 in IRS Publication 590-A.

When can you withdraw from a traditional IRA?

You can start taking qualified distributions without penalties when you reach the age of 59½. Any early withdrawals before you reach the age of 59½ are hit with a 10% penalty fee plus income taxes on the amount you withdraw.

Qualified distributions have no penalties, but are taxed as regular income since you deferred your taxes when you contributed.

Can I take out my contributions like with a Roth IRA?

With a Roth IRA, you’re allowed to withdraw your contributions at any age without penalties. With a traditional IRA, you’re not allowed to take any money from your account without getting hit with penalties.

Is there a 5-year rule?

There is no 5-year rule. This only applies to the Roth IRA and other Roth retirement accounts. With a Roth IRA, in addition to being over the age of 59½, your account must also be at least 5 years old. With a traditional IRA, as long as you’re 59½ or older, you can start making withdrawals even if your account is under 5 years old.

Required minimum distributions (RMD)

A traditional IRA has required minimum distributions. Unfortunately, you can't differ your taxes and keep your account compounding forever. You must start taking distributions from your retirement account when you reach the age of 72. A Roth IRA, on the other hand, has no required minimum distributions.

Contribution limits

The contribution limit for a traditional IRA is $6,000 for 2022 and $6,500 for 2023. If you're over the age of 50, the traditional IRA also gives you an additional $1,000 in catch-up contributions. Your contribution limits are $7,000 for 2022 and $7,500 for 2023.

How to open a traditional IRA

You can open a traditional IRA with most banks, credit unions, brokerages, and robo-advisors. All you need to contribute to your account is any amount of taxable income. There are no age or income limits. You can contribute to a traditional IRA even if you're in high school, earning extra pocket money with a weekend job.

You're also allowed to contribute to a traditional IRA even if you contribute to a 401k plan at your full-time job.

What can I invest in?

With most traditional IRA providers, you can invest in individual stocks, mutual funds, bonds, and ETFs. You're also allowed to invest in alternative assets like crypto and real estate, but you must open a self-directed traditional IRA.

Traditional IRA vs Roth IRA

A Roth IRA has different tax benefits than a traditional IRA.

A traditional IRA defers taxes until retirement. You contribute with money that you haven't paid any income taxes on yet. Instead, it gets deducted from your taxable income, giving you an immediate tax break when you contribute. Your money grows tax-deferred until retirement. When you take qualified distributions starting at the age of 59½, you pay regular income taxes on your withdrawals.

With a Roth IRA, you pay income taxes when you contribute. You get no immediate tax breaks, but your withdrawals in retirement are completely tax-free.

Traditional IRA vs SEP IRA

A SEP IRA has bigger tax advantages than a traditional IRA. For both a SEP IRA and traditional IRA, you make contributions with pre-tax dollars and defer your tax payments until retirement.

However, a SEP IRA has a contribution limit that's 10x larger than a traditional IRA. You can contribute up to $61,000 for 2022 and $66,000 for 2023.

The SEP IRA is designed for business owners. In order to be eligible, you must be self-employed, or a business owner with zero or few employees. On the other hand, anyone with any earned income is eligible for a traditional IRA.

Traditional IRA vs 401k

A 401k and traditional IRA are completely different plans.

A 401k is employer-sponsored. In order to receive a 401k, you must work for a company that sponsors a plan for their employees. You can contribute up to $20,500 for 2022 and $22,500 for 2023. If you're over the age of 50, you can contribute up to $27,000 for 2022 and $30,000 for 2023.

A 401k has fewer investment options than a traditional IRA. You usually can't invest in individual stocks or alternative assets like crypto and real estate. Instead, you're limited to around a dozen mutual funds selected by your employer.

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