Traditional IRAs: A Tax Advantaged Way to Save for Retirement

If you haven't started saving for retirement, there's no better time than now. Lucky for you, there are a ton of investment options out there to build your retirement savings. When choosing which is right for you, there are a variety of factors to consider: from eligibility and required minimum distributions to tax returns and filing policies. 

In this article, we’ve broken down the traditional IRA, a retirement planning tool that can lead to sizable capital gains in your future. Learn more about what a traditional IRA is, the tax benefits, and how to open an account.

What Is a Traditional IRA?

A traditional individual retirement account (IRA) is one of the most popular investment accounts used to save for retirement.

Most notably, traditional IRAs are made up of pre-tax dollars and grow tax-deferred — this just means that your money won't be taxed when you put it into the account, but it is taxed when you make withdrawals down the road.

The tax timeline here is important because there are certain tax advantages to traditional IRAs — particularly for individuals who think they will be in a lower tax bracket in retirement. Since all traditional IRA withdrawals are taxed at the same rate as income, people who will be in a lower tax bracket in retirement will pay less in the future and may get tax deductions during the peak of their income gains. In contrast, other retirement accounts like the Roth IRA are not tax-deductible; this may be better for those who will be in a higher tax bracket in retirement. 

However, there are certain requirements that must be met in order to achieve the full tax deduction benefits of a traditional IRA.

Meeting the Eligibility Requirements 

Your eligibility to open a traditional IRA depends on a few factors. Two major ones to consider for those looking to start their own account are age and taxable compensation.

Age

In order to open a traditional IRA and make contributions towards it, you must be younger than 70 ½ years old. Individuals older than that are not allowed to open a traditional IRA because they would be prohibited from making any contributions to it. 

At the other end of the spectrum, anyone over the age of 18 can open their own IRA account; minors with part-time/full-time jobs may also open custodial accounts with the help of an adult.

While there isn’t a magic age for when you should open an IRA, it is widely considered better to open an IRA when you are younger because of compound interest — basically, interest accrues on top of interest. By starting at a younger age, individuals may reap massive benefits in the future. 

Taxable compensation

Taxable compensation refers to the amount of income you earn that is subject to taxation. In order to open a traditional IRA, you must have taxable compensation.

There are certain exceptions to taxable income; for instance, not all PhD trainees may be eligible to make contributions towards an IRA because their ‘income’ may not be considered taxable. However, as long as a portion of your income is considered taxable compensation, you will be eligible to open and contribute to a traditional IRA. That’s why even minors with a part-time job that provides taxable compensation can open a custodial IRA account with the help of a legal guardian and/or adult. 

If you are a nonworking spouse with no taxable income, you can open a traditional IRA by filing a joint tax return with your working spouse. In order for this to work, your working spouse must have enough taxable compensation for both them and you to make contributions to your individual IRAs.

Contributions & Their Limitations

To prevent highly paid workers from benefitting more than the average worker from tax advantages, traditional IRA contribution limits are set for how much money an individual can put into their account annually.

As stated by the Internal Revenue Service (IRS), the annual contribution limit for a traditional IRA for 2021 is $6,000, or $7,000 if age 50 or older — note that contribution limits are changed over time by the IRS due to a variety of factors. 

Since the annual contribution limit is quite high, individuals can automate their contributions and have money deposited to their IRA weekly, biweekly, or monthly — whatever may be the best fit. By automating the system, people can make smaller payments throughout the year and maximize their IRA for the future. 

Tax Deduction Limits

While there are no income limitations for opening a traditional IRA, your income does affect your tax-deductible contributions.

If you (or your spouse if you are married) already contribute to a retirement plan at work, there are income limits that restrict how much you can deduct from your IRA contribution.

According to the IRS, here are the 2021 income limits if you are covered by a retirement plan at work, sorted by filing status:

According to the IRS, here are the 2021 income limits if your spouse is covered by a retirement plan at work, sorted by filing status:

Are There Any Penalties?

There are two notable penalties that you should consider before opening a traditional IRA: early withdrawals and required minimum distributions (RMDs). Let's look at them both.

Early withdrawals

The IRS sets the golden number for retirement at age 59 ½. Pulling funds from your IRA before this age can trigger a 10% early withdrawal penalty and tack on additional income taxes.

Only in certain IRS-approved situations can an individual younger than 59 ½ years old withdraw from a traditional IRA account without penalties. Here are a few exceptions:

• Unreimbursed Medical Expenses: Those without health insurance or with medical expenses not covered by insurance may take penalty-free distributions from their traditional IRA to cover those costs. In order to qualify for this exception, you must (1) pay the medical expenses during the same calendar you make the withdrawal and (2) the expenses must exceed 7.5% of your adjusted gross income.
• Health Insurance Premiums While Unemployed: If you are unemployed you may use funds from your IRA without penalty to cover health insurance premiums. In order to qualify for this exception, you must have (1) lost your job, (2) received unemployment compensation for 12 consecutive weeks, (3) taken out distributions during either the year you received the unemployment compensation or the next year, and (4) received the distributions no later than 60 days after going back to work. 
• A Permanent Disability: If you become permanently disabled and are no longer able to work, you may tap into your IRA funds at any time, for any purpose, without penalty. However, before making withdrawals, you must provide proof of your disability. 
• Higher-Education Expenses: In certain cases, you may use funds from a traditional IRA before reaching 59 ½ years of age to pay off higher education expenses — like college loans, education materials, etc. — for yourself, your spouse, or your child. This is dependent on the situation, and you should consult with your tax professional before making any withdrawals for this purpose. 
• Inheriting an IRA: If you inherit an IRA, you are not subjected to the 10% early withdrawal penalty. However, if you are the spouse of the original account holder, the 10% penalty still applies because the IRA is treated as if it was yours in the first place.

Learn more about other exceptions here.

Required minimum distributions

When you reach age 72, you must begin taking required minimum distributions (RMDs) every year.

Your RMD is calculated by dividing the prior December 31 balance of your IRA by a life expectancy factor that the IRS publishes annually; your RMD will most likely be different every year and must be recalculated by either yourself or your tax consultant. 

Who Is a Traditional IRA For?

With so many different types of retirement options out there, consider these key points when deciding on a traditional IRA in order to make the right choice for your financial future. 

Why you might want to start a traditional IRA:

• You expect to be in a lower tax bracket when you retire: Since funds in a traditional IRA are taxed at withdrawal, you'll owe less if you're in a lower tax bracket during retirement than you would if you had to pay taxes now while in a higher tax bracket. 
• You want tax-deductible contributions: Unlike a Roth IRA, you can benefit from tax breaks because your contributions are tax-deductible on your federal tax returns.

Why it might not be the right choice for you:

• You are in a lower tax bracket right now: For young investors starting out their careers, a Roth IRA might be a better option since you may be taxed at a higher rate in retirement.
• You plan on using the money before turning 59 ½ years old: Compared to the traditional IRA, other retirement plans like the Roth IRA do not impose any early withdrawal penalties on contributions (earnings, however, do incur penalties for early withdrawal). For those who think they will need to tap into their funds earlier — and are not qualified for any exceptions — the traditional IRA might not be for you.

If these predictive scenarios feel overwhelming to you...

There is also no limit to how many IRA accounts you can own. So, it may be beneficial to open multiple IRAs — for instance owning a traditional IRA and a Roth IRA — so that you can maximize the tax incentives and investment opportunities of both types of accounts. 

Takeaways

Ultimately, there are many types of retirement options out there, and the best choice requires assessing your personal needs, and what would make the best fit. With the right IRA account, you may be able to financially secure your future for you and your family, or be able to use your funds to invest in future endeavors.

Although retirement may seem far in the future, it’s never too early to begin investing. Visit your local financial institution to open your IRA today!