What is a Traditional IRA and How Does it Work?
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- With a traditional IRA, you may be able to pay less current year taxes on your retirement contributions.
- A traditional IRA can be a good place to roll over your 401(k) if you change jobs.
- There are different investment limits for a traditional IRA if you’re under or over the age of 50.
How does a traditional IRA work?
If you’re investing for retirement, you’ve likely heard about a traditional IRA. But what is a traditional IRA, exactly? And how do you decide if it’s a good financial option for you?
A traditional IRA is a special type of financial account that lets employees save tax-deferred money for retirement. When you contribute money to a traditional IRA, you skip paying upfront federal and state income taxes on those funds. Instead, you pay taxes on your money later, when you withdraw it — typically during retirement.
This is the big advantage of investing in a traditional IRA. During retirement, you may be in a lower tax bracket than when you were working. As a result, you could end up paying less in taxes on your investments.
What Are the Benefits of Traditional IRA Accounts?
There are several reasons why you might consider opening a traditional IRA. First, if your employer doesn’t offer a workplace retirement plan, a traditional IRA gives you the ability to create your own.
Second, if you have a workplace retirement plan but end up switching jobs, a traditional IRA can be a good place to roll over your 401(k) funds. After all, you might not be allowed to keep your retirement money with your former employer—or you might not want to. A traditional IRA lets you take your retirement money with you and continue to keep the account tax-protected.
Last but not least, a traditional IRA may allow you to pay less in taxes. For example, a 35-year-old who has a $150,000 annual salary can invest up to $6,000 per year in a traditional IRA in 2020. That contribution reduces their taxable income to $144,000, resulting in a lower tax bill at the end of the year.
Why Is This Account Called a ‘Traditional’ IRA?
There are two basic types of IRAs: traditional IRAs and Roth IRAs. Depending on your income and tax situation, you’re able to invest in either one or both of these investment accounts. Learn more about traditional vs. Roth IRAs to determine which might work best for you.
Is a traditional IRA a type of investment?
No, an IRA is not an investment itself—it’s a special kind of container that holds your investments.
In general, you can include almost any type of investment in a traditional IRA account—from bonds to mutual funds and exchange-traded funds (ETFs). You can design your IRA to be as financially conservative or aggressive as you like.
Traditional IRA Rules and Contribution Limits
Traditional IRAs do have a few limitations and trade-offs that you should consider. Your financial advisor can help you determine how the following rules will impact you:
- Income limits: Anyone with earned income can deposit money into a traditional IRA. However, you’ll only receive a tax deduction if you earn less than the IRS-mandated annual limit.
- Contribution rules: As of 2020, you can put up to $6,000 in a traditional IRA. If you’ll be age 50 or older by December 31, you can add another $1,000 to that amount.
- Mandatory withdrawals: The IRS requires you to start taking money out of your traditional IRA—and paying taxes on it—every year, starting at age 72. These withdrawals are called required minimum distributions (RMDs). RMDs kick in after age 72 (unless you’ve reached 70 ½ in 2019).
Can My Spouse and I Both Open Traditional IRAs?
Absolutely. The exact contribution guidelines and tax rules for a traditional IRA will vary according to your incomes, whether you have work retirement accounts and whether you file your income taxes separately or jointly.
An IRA can be a valuable part of almost any investor’s retirement strategy. If you happen to fall within the income limit, a traditional IRA can give you a nice upfront tax break, too.
What You Can Do Next?
Compare the benefits of traditional and Roth IRAs. Your financial professional can help you decide whether a traditional IRA is right for you.
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