A traditional IRA’s primary advantage is that it allows you to fully or partially deduct contributions from your taxable income for the year you contribute. This could lower your taxable income in your higher-earning years. The money you put into an IRA, as well as the money it earns, isn’t taxed until you take it out of the account. This is an advantage if your income (and therefore taxes) are lower in retirement. You can contribute to a traditional IRA if you have taxable compensation, such as what you earn from working. Compensation can also include self-employment income, commissions, and taxable alimony and maintenance. It doesn’t include income earned from some other sources, including rental properties, deferred compensation, interest income, dividend income, or income from a pension or annuity. You can contribute to a traditional IRA if you or your spouse participate in a retirement plan through work. For 2022, your total contribution to all IRAs (traditional and Roth IRAs) is limited to $6,000 or your taxable compensation for the year, whichever is less. At age 50 or older, you can make “catch up” contributions of up to $7,000. If you are age 70 ½ or older, you may contribute any amount to your traditional IRA in a year, with no limit.
Contributions Are Deductible
Contributions to a traditional IRA are eligible for a tax deduction in the year they were made. The taxes are not actually forgiven, but are deferred—you’ll pay normal income tax on the money when you withdraw it. Your annual deduction may be limited by your income and whether you’re in a retirement plan through work.
Withdrawals
You can withdraw assets from your traditional IRA account at age 59 ½. When you’re 72 ½, you must begin taking withdrawals each year from your traditional IRA of a specified amount, called a required minimum distribution (RMD), and include the withdrawal in your tax return for the year. If you take money from your account before you reach age 59½, you will pay any taxes and a 10% additional penalty.
Example of a Traditional IRA
Suppose you’re a single 30-year-old, and make $85,000 per year through your job. Your employer doesn’t offer a retirement plan, and you don’t have any retirement plan in place at all. You set up a traditional IRA with a financial institution in 2022. You decide to put $6,000 of your earned income from your job into the IRA by the deadline, which is the April due date for your tax return in the year following the year you’re filing a return for. You can invest this amount in stocks, bonds, mutual funds, or other similar securities. Or you could put the $6,000 into an IRA savings account or CD at a bank. Because your workplace doesn’t offer any sort of retirement plan, you can probably deduct the full amount from your taxes. Next year, you can make another contribution up to that year’s maximum. If next year, you decide to take out, say, $1,000 of this amount, you will have to pay income tax on the withdrawal, based on your tax rate for the year, plus a 10% penalty.
Roth IRA vs. Traditional IRA
A Roth IRA is the other common type of IRA individuals tend to set up, but you contribute to it with after-tax dollars instead of pretax dollars. Here are the primary differences between a Roth IRA and a traditional IRA.
