Traditional IRA: What is it and how does it work?

Saving for retirement is one of the most important financial steps you can take, and a Traditional IRA (Individual Retirement Arrangement, commonly called an Individual Retirement Account) is one of the most popular and time-tested vehicles for retirement savings.  It offers valuable tax advantages and flexibility, making it a powerful option for building long-term wealth.

In this guide, we’ll break down what a Traditional IRA is, how it works, who can benefit from it, and how it compares to other retirement accounts—all in simple, actionable terms.

What Is a Traditional IRA?

A Traditional IRA is a tax-deferred retirement savings account allowing contributions of pretax income, relieving the taxpayer of tax obligations now and saving for the future. A traditional IRA is a personal savings plan that is authorized by the IRS, giving your money a powerful tax advantage as it grows. Unlike employer-sponsored plans such as a 401(k), the Traditional IRA is one you open yourself, making it a wonderful fit for anyone with any earnable income, including self-employed individuals and those with their own workplace plans. The money in your IRA grows tax-deferred until you begin making withdrawals during retirement.

Tax Benefits of a Traditional IRA

The defining feature of a Traditional IRA is its tax treatment, which is based on the principle of tax deferral. This means you generally get your tax break now, and you pay the taxes later.

Tax-Deferred Growth: The Power of Compounding

When you invest money inside a Traditional IRA, your investments—whether they’re stocks, bonds, mutual funds, or ETFs—grow without being subject to capital gains, dividends, or interest taxes each year. This is called tax-deferred growth.

• Tax Deferral Advantage: Since you aren’t paying annual taxes on gains, all of your earnings are reinvested, allowing your money to compound faster than in a regular, taxable brokerage account.
• Taxes Paid Later: You only pay income tax on your contributions and earnings when you withdraw the money during retirement. The IRS views these retirement withdrawals as normal income for that year.

Immediate Tax Deduction: Lowering Your Taxable Income

Immediate tax-advantaged benefits from investing in a Traditional IRA are among the biggest incentives.

• Deductible Contributions: Depending on your income and whether you (or your spouse) is covered by a retirement plan at work, your contribution to a Traditional IRA may be fully or partially tax-deductible.
• Lowers Current Taxable Income: A deductible contribution directly reduces your adjusted gross income (AGI) for the tax year in which you make the contribution, which in turn could lower your overall tax bill currently.

For Example, if you put $7,000 in a Traditional IRA and the contribution is deductible in its entirety, you can deduct that amount from taxable income in that year.

How the Traditional IRA Works: Contributions and Eligibility

To start saving in a Traditional IRA, you must first understand the rules regarding who can contribute and how much they can put in each year.

Who Can Contribute to a Traditional IRA?

The eligibility rules are relatively simple:

Earned Income Required: You must have taxable compensation (earned income) for the year, such as wages, salaries, commissions, self-employment income, or alimony/separate maintenance payments (if received under a pre-2019 agreement).

No Age Limit (Post-SECURE Act): Unlike the old rules, there is no maximum age limit to contribute to a Traditional IRA, provided you have earned income.

Annual Contribution Limits

The IRS sets annual limits on the total amount you can contribute to all your IRAs (Traditional and Roth combined).

Spousal IRA: If you’re married, file jointly, and one spouse earns very little or nothing, the other spouse can contribute for the non-working spouse up to the annual limit if the couple’s combined earned income meets the requirement.

Income Limits and the Deduction Cliff

While there are no income limits for contributions into a Traditional IRA, there are income limits regarding deductions. This is for those whose spouse or themselves is engaged in a workplace plan for retirement (such as 401(k)).

• If you and your spouse are not covered under a workplace plan, all of your contributions are fully deductible, irrespective of income.

You can also check with an expert tax professional, or you can use IRS guidelines to know your deduction eligibility figures for the particular year.

Withdrawal Rules and RMDs

If taxes were to be withheld indefinitely, then the Traditional IRA would be almost a full circle in the access regulations regarding this money.

Early Withdrawals: The Penalty Risk

The government wants you to use this money for retirement, so withdrawing funds before age 59½ generally comes with a hefty penalty.

Tax and Penalty: Generally, early withdrawal before the age of 59 is subject to ordinary income tax, and there is a 10% early withdrawal penalty.

Exceptions to the Penalty: The IRS provides several exceptions to avoid the penalty, although income tax would still apply most of the time. Some of those exceptions include:

• Purchase of a first home (lifetime limit reaches $10,000)
• Higher education costs are exempt
• Unremunerated medical expenses
• Payments thereafter, when one has become completely disabled and permanent

Required Minimum Distributions (RMDs)

Since the cash has been delayed in taxes, at a later time, the government must require you to remove it so that taxes can be collected. This is called Required Minimum Distributions (RMDs).

• Starting Age: You must begin withdrawing from your Traditional IRA usually by April 1 in the year after you turn age 73. (That age was recently increased by law).
• Annual Calculation: The RMD amount is calculated on the balances of your account and your life expectancy, according to publications from the IRS.
• RMD Penalty: A severe penalty tax in the amount of the unpaid RMD would be charged on the date proceeds are not drawn.

Traditional IRA vs. Roth IRA: Which Is Best for Me?

When you look at the different types of IRAs, they often come down to the Traditional IRA vs. the Roth IRA. It’s all about when you receive your tax relief.

The “Tax Now vs. Tax Later” decision depends on your expected tax bracket now versus in retirement:

1. Choose a Traditional IRA if: You expect to be in a lower tax bracket at retirement than you are now. The upfront deduction is generally more valuable to you today, and the best case is to pay tax at a lower rate later.
2. Choose a Roth IRA if: You expect to be in a higher tax bracket in your retirement. Paying taxes at a lower rate now, then enjoying tax-free growth and withdrawals later, is the way to go.

Key Takeaways for the Traditional IRA

The Traditional IRA is an integral part of retirement, allowing an individual to use serious savings methods over the long term by capitalizing on the tax structure. 

Strong Tax Deferral: Your growth in investments is deferred from paying annual taxes, maximizing the compounding power. 

Instant Tax Break: It might help reduce your current tax bill due to deductible contributions. 

Flexibility: The investment style that works for you may put your money in an account. Even if you have a 401(k), you can open an account.

How to Open a Traditional IRA

Starting a Traditional IRA is simple and can be done online in minutes. Here’s how:

1. Choose a Financial Institution

You can open an IRA through banks, brokerages, or robo-advisors such as:

• Fidelity
• Vanguard
• Charles Schwab
• Betterment

2. Fund Your Account

You can:

• Transfer money from your checking/savings account
• Roll over funds from another retirement plan (like a 401(k))

3. Pick Your Investments

Decide how to allocate your funds based on your risk tolerance and time horizon:

• Conservative: Bonds and money market funds
• Balanced: A mix of stocks and bonds
• Aggressive: Stock-heavy portfolio for long-term growth

Pros and Cons of a Traditional IRA

Pros:

• Immediate tax deduction
• Tax-deferred growth
• Flexible investment options
• Ideal for those without a 401(k)

Cons:

• Taxes on withdrawals
• Penalties for early withdrawals
• Mandatory RMDs starting at 73

Smart Strategies for Maximizing Your IRA

1. Make contributions early and consistently: The earlier you invest, the more you take advantage of compound growth.
2. Diversify your investments: Disperse your funds among stocks, bonds, and ETFs to maintain a balance.
3. Early withdrawals: Don’t make early withdrawals, if possible. Even during a downturn, try to leave the money in your IRA for the long run.
4. Conduct an annual review: Review and adjust your investment strategy based on your age and goals.

Final Thoughts: Is a Traditional IRA Right for You?

The Traditional IRA serves as an excellent option for anyone interested in tax-deferred growth and flexible options for retirement savings. This is a great vehicle to consider if you want to reduce your current tax bill; however, the tax code is complicated. You should always consult a qualified financial advisor or tax professional to help these strategies work the best for your personal income, filing status, and overall financial plan. There is no better beginning to a comfortable tomorrow than beginning your IRA savings habits today.

Traditional IRA – Frequently Asked Questions (FAQ)

Q: What is a Traditional IRA?

A: A Traditional IRA is an individual retirement account that provides an opportunity for personal retirement savings with tax-deferred earnings and tax-deductible contributions. Earnings are generally taxed when withdrawn during retirement.

Q: Are contributions to a Traditional IRA tax-deductible?

A: Contributions may be tax-deductible. Qualification for deduction in part or in full is determined by:

• Income (improved adjusted gross income or MAGI).
• Tax filing status (Single, Married Filing Jointly, etc.).
• Whether or not you (or your spouse) are covered by a retirement plan at work (for example, a 401(k)).

If you are officially not covered by a workplace plan, then generally your contribution is fully deductible; if you are covered, then that deduction may be eliminated or reduced at higher levels of income.

Q: What is the maximum amount I can contribute to my Traditional IRA?

A: For the years 2024 and 2025, the maximum annual contribution limit will be:

• \$7,000 if you are under age 50.
• \$8,000 if you are age 50 or older (with a \$1,000 catch-up contribution).

Contributions cannot exceed taxable earned income for the year.

Q: Can I contribute to both a Traditional IRA and a 401k?

A: Yes, one can contribute to both an IRA and an employer-sponsored plan like a 401k. However, depending on your income, your participation in a 401k may limit or eliminate the tax-deductibility of your Traditional IRA contribution.

Q: By when can I make contributions?

A: Generally, the deadline for contributions for the applicable tax year is the due date for filing your federal income tax return for that year (which is usually April 15 of the following calendar year), without extensions.

Q: May I take money out before retirement age?

A: You can withdraw funds at any time. However, pre-retirement withdrawals of pre-tax amounts (contributions and earnings) before age $59\frac{1}{2}$ are typically 10% additional tax (penalty), unless an exception applies (first-time home purchase, qualified higher education expenses, disability, and a few others).

Q: By what date must I begin withdrawing funds?

A: You must begin withdrawing funds from your Traditional IRA by taking Required Minimum Distributions (RMDs), which must begin in the year you attain age 73 (or $70\frac{1}{2}$ or 72, depending on your year of birth). If you fail to take your RMD, you will incur a penalty.