Eligibility and Income Limits
Anyone with earned income from a job can contribute to a Traditional IRA regardless of how much that income is. However, there are income limits for deducting those contributions from taxes if the account holder or a spouse is covered by a workplace retirement plan, like a 401K. To calculate the acceptable deduction, you'll need to compare your modified adjusted gross income (MAGI):
- Single Filers: Full deductions are allowed if MAGI is $77,000 or less. Partial deductions are allowed if MAGI is between $77,000 and $87,000. Individuals over $87,000 cannot deduct Traditional IRA contributions from their taxes.
- Married Filing Jointly: Full deductions are allowed if MAGI is $123,000 or less. Partial deductions are allowed if MAGI is between $123,000 and $143,000. A couple who makes over $143,000 cannot deduct Traditional IRA contributions from their taxes.
Contribution Limits
The IRS sets annual contribution limits for Traditional IRAs. As of 2024:
- Less than Age 50: Can contribute up to $7,000 per year.
- Age 50+: Can contribute up to $8,000 per year (inclusive of a $1,000 catch-up contribution).
- These limits are combined for all IRA accounts. For example, if someone has both a Roth IRA and a Traditional IRA, the total contribution to both cannot exceed the limit.
These limits can change, so staying up to date with the IRS guidelines is essential.
Tax-Deferred Growth
- The money in a Traditional IRA grows tax-deferred, which means that taxes aren't paid on the investment gains each year (they will eventually be paid on withdrawal). This allows the investments to compound more effectively over time.
- For instance, if Jordan invests $6,000 every year with an average return of 6%, after 20 years, their investment could grow to over $230,000, without any taxes paid on the gains during that period.
Withdrawal Rules
- One of the main benefits of a Traditional IRA is the potential for tax-deductible contributions. This means that the money contributed to an IRA can reduce taxable income for the year, depending on income level and whether a retirement plan at work covers the account holder or their spouse.
- When withdrawing money from a Traditional IRA during retirement, income tax at its current rate is paid on those withdrawals. Because of the tax deduction received on the original contributions, the IRS requires taxes to be paid when the money is taken out. Planning for these taxes in a retirement income strategy is vital to avoid surprises.
Required Minimum Distributions (RMDs)
Starting around age 70, individuals must take minimum distributions or withdrawals from their Traditional IRA. The IRS calculates these RMDs based on life expectancy and the balance in the account, but as a general rule of thumb, in 2024, they will start being required at:
- 73 if you turn age 72 on or after Jan. 1, 2023
- 72 if you turn 70½ between Jan. 1, 2020, and Dec. 31, 2022
- 70½ if you turned that age on or before Dec. 31, 2019
If the required amount isn't taken out, a hefty penalty of 50% can be incurred on the amount that should have been withdrawn but wasn't. Account holders can also take more than the RMD, but not less.
Advantages of a Traditional IRA
- Immediate Tax Benefits: Contributions might reduce taxable income in the year they are made, offering immediate tax savings.
- Flexibility: Can invest IRA funds in various assets, including stocks, bonds, mutual funds, and ETFs.
- No Income Limits for Contributions: Unlike Roth IRAs, no income limits prevent contributions to a Traditional IRA.
Disadvantages of a Traditional IRA
- Withdrawal Taxes: Taxes will be owed on the money when it is withdrawn during retirement, which could fluctuate significantly from the tax rate when the money was contributed.
- RMDs: RMDs start in the account holder's 70s, forcing them to take out money and pay taxes on it, regardless of whether they need it.
Comparison to Roth IRA
- Tax Treatment: Roth IRAs are funded with after-tax dollars, meaning contributions are not tax-deductible, but withdrawals are then tax-free because taxes were paid on the original contribution.
- Income Limits: Roth IRAs have income limits for contributions, while Traditional IRAs do not, making them more accessible to everyone.
- RMDs: Roth IRAs do not require RMDs during the original account holder's lifetime, unlike Traditional IRAs.
Tips for Maximizing a Traditional IRA
- Start Early: The earlier one starts contributing, the more time the investments have to grow tax-deferred.
- Maximize Contributions: Try to contribute the maximum allowable amount each year to take full advantage of the tax benefits and compound growth. This helps with starting early and compounding as much of a return as possible.
- Diversify Investments: Spread investments across different asset classes to reduce risk and enhance potential returns. Riskier investments with higher returns are common the younger the account holder, and they lessen as one nears retirement age and needs to withdraw. The S&P reports an average of 10.8% return on investments made with a Traditional IRA, given data from 1970 through 2020.
- Monitor RMDs: Track required minimum distributions to avoid penalties, which could otherwise be money that could be utilized in retirement.
