What is a Traditional IRA you ask? A Traditional IRA is the original Individual Retirement Account (IRA). It was created in the Tax Reform Act of 1986 to provide better incentives for retirement savings. The US government decided to make IRA investment contributions tax free. The government made it cheaper for the citizens of the US to invest in their own retirement. Making a traditional IRA investment today costs you 25-35% (depending on your tax bracket) less than an investment would cost outside of an IRA.
Traditional IRA Tax-deduction
An example most easily shows the tax benefits of an IRA:
Bill grosses $40,000 a year and is in the 25% tax bracket. With these numbers, Bill loses $10,000 to the IRS in taxes. Of his net $30,000 he would like to invest $3000 in gold not involving his IRA (so as a normal investment). Bill’s $3000 net income after taxes was really $4000 gross income. Simply put, Bill’s investment in gold is taxed 25% as part of his income.
Now let’s say Bill decides to use an IRA to invest in gold. Bill now qualifies for a tax-deduction. Bill was making $40,000, but now he invested $3000. Now the government sees his yearly income as $37,000 because of his tax deductible IRA contribution. Whatever Bill donates to his IRA is deducted from his yearly income. Bill gets to invest with a 25% discount through his traditional IRA!
The tax man always finds a way however. When you become 59½ you are eligible to start withdrawing your IRA funds. When you do withdraw, you will be subject to taxes. Whatever Bill withdraws when he is 60 and above, he will pay the tax rates for that current year like he is making income. The way a Traditional IRA works is by tax-deducting now, and paying on withdrawal later.
So what is a Traditional IRA? It is a constructed tax loop that provides excellent returns on investments and retirement. The power of an IRA account is astounding. After 30 years of investing $5,000 a year one can reach a million dollars or more for retirement!
What are Traditional IRA Investments
IRA investments vary upon the type of IRA you have. Self-directed IRAs have many options, as you are doing most of the investing. Roth IRAs have more options than the traditional IRAs as well. Popular IRA investments include mutual funds, bonds, and index funds. With a traditional IRA, you have relatively few options. But the options are not the point, the income is, and all types of investing usually even out in the long run. Simply ask a financial analyst or broker to invest your IRA funds for you—unless you think you can handle the markets on your own (not recommended).
IRA returns, if you invest correctly, are usually the average of the market and historically have been between 8 and 12%. When considering the return of an IRA, remember that short term variance in markets can gain or lose much more than the average yearly appreciation of 8-12%. Do not think you are an investing genius for having a good +25% year. Also do not think IRAs are doomed for having a bad -10% year. The variance evens out to 8-12% in the long run.
If you do not want to work with a broker a self-directed IRA allows you to invest on your own. While some do this successfully, this takes skill and the self-directed IRA investors run the risk of making bad investments. Single investments become more of a gamble. A gamble is not what your retirement needs to be riding on. Your traditional IRA can easily be allocated to mutual or index funds and left to the experts—people who spend their whole lives watching markets–lowering the variance and your stress levels.
What are Traditional IRA Rules?
Traditional IRA rules are fairly straightforward but need some explaining; we’ll hit the key points.
- You can contribute a maximum of $5,000 per year. If you are over 50 this raises to $6,000 per year. The IRS allows the older investors to play catch up with the increased contribution rate.
If you file as single or married filing separately
- You can contribute the full amount if you make less than $56,000
- You can contribute a calculated lesser amount if you make between $56,000 and $66,000
- You cannot contribute if you make more than $66,000
If you file jointly and you are not covered by employee-sponsored retirement plan
- You can contribute the full amount if you make less than $90,000
- You can contribute a calculated lesser amount if you make between $90,000 and $110,000
- You cannot contribute if you make above $110,000
If the above rules make you ineligible for an IRA contribution it must be nice! But really, what you may want to try is a Roth IRA, the contribution limits are higher in that type of IRA
The Traditional IRA has penalties for withdrawing before you are 59½. The IRS charges the tax rate plus 10% to any withdrawals before this age. However there are some exceptions to this rule. The exceptions for this rule are withdrawals for the following reasons:
- You have unreimbursed medical bills that excdeed 7.5% of your adjusted gross income (AGI)
- You are disabled
- The distribution is a qualified reservist distribution
- The distributions are used on a first home.
- You receive the distributions in the form of an annuity
- There are a few more exceptions and fine print to these rules, please make sure to lookup all of the exact rules before you withdraw early.
What is Required Minimum Distribution?
< href="/required-minimum-distribution">Required minimum distribution or RMD is the traditional IRA’s way of forcing you to withdraw from your IRA (and pay the tax man). You must withdraw calculated distributions by the age of 70½ or face further steep penalties. The penalty for not withdrawing on time is 50% of the withdrawal calculation for that month on top of taxes. Your required minimum distribution is a calculation based on your current balance in the IRA account—there are calculators out there that will estimate this. Many retired individuals do not like the required distribution rule, as they would like to maximize their retirement income for as many years as possible. The required minimum distribution rule is unavoidable with a Traditional IRA. The only way to avoid this rule is to have a Roth IRA instead of Traditional.
The Bottom Line
A traditional IRA is an investment vehicle that stands apart from the crowd. This investment type literally lets you cheat the typical system. If you expect to be in a lower income bracket in retirement (many will be), then a traditional IRA is perfect for you. While there are many positives to investing in a traditional IRA, please do not consider a traditional until you have fully reviewed a Roth IRA (the traditional IRA’s partner in crime). Many people consider the Roth IRA just as valuable or more valuable though the rules work differently. Regardless, do your homework on these issues and preparing for your retirement will be a breeze. Good luck!