Your smart and simple guide to Traditional IRAs

Aman Saxena

There is a lot of talk about IRAs when it comes to saving for retirement, but what does it actually mean? For many people, all the acronyms thrown around for retirement planning can be hard to keep track of, let alone understand the tax laws regarding each.

And on top of that, it is estimated that around 15% of American’s don’t have anything saved for retirement, according to Northwestern Mutual’s 2019 Planning & Progress Study.

Read on and take a deep dive into understanding one of the benchmarks of retirement planning in the US- Traditional IRAs. And it goes without saying, it is highly suggested to consult a tax or retirement planning advisor about your own unique financial situation to help you decide the best steps for you.

📝 Table of contents

What is a Traditional IRA

An Individual Retirement Account, or IRA, is a tool for individuals, married couples and employers to use to save for retirement.

IRAs are vehicles set up by institutions with approval from the IRS, such as your local bank or an investment firm. IRAs help to provide tax relief for individuals that make proactive contributions to save for retirement. The tax relief, whether now or in the future depending on the IRA you choose, is to help incentivize Americans to put money away for their retirement.

There are 4 main types of IRAs:

There are also Spousal IRAs and Inherited IRAs, as well as 401(k) plans which can be rolled over into an IRA, and are covered in a later section.

A Traditional IRA can only be funded through income earned through a salary or work earnings. Funds that come through an alimony for example can not be put towards an IRA.

An individual or a married couple can open a Traditional IRA. A Traditional IRA can not be opened for children, unless designated as a minor with a parent or guardian as an owner, or the child is of age to begin earning wages.

🎯 Quick Take: Traditional IRA
  • Funded by wage, salary or work earnings
  • Taxes are taken out in retirement
  • A tax deduction can be taken in the present
  • Traditional IRAs can have market exposure
  • Distributions are required

How do Traditional IRAs Work

Let’s break down what happens with a Traditional IRA.

As mentioned, a Traditional IRA is funded with pre-tax dollars from earnings. The logic behind setting up the Traditional IRA this way is that you are expected to have a lower income tax rate in retirement.

So instead of paying taxes on the income now, you can write it off on your taxes as a tax deduction at your current tax rate. And then when you get to retirement, having saved up the money this entire time, you will pay taxes at the lower tax rate when you take the funds as income.

You can open a Traditional IRA at any financial institution that is approved by the IRS. So this includes most local banks, mutual fund firms, investment firms, brokers and even certain insurance companies. Check with the bank you regularly bank with if you can open an IRA with them. Often, you can even open one online.

ℹ️ Traditional IRAs don’t have a maximum or minimum income requirement and are open to anyone earning an income.

One thing to note about a Traditional IRA is that it is open to everyone. Unlike a Roth IRA that has income limits which disqualify high wage earners, a Traditional IRA does not have any stipulations on earned income.

If you have an existing retirement plan at work, you can still open a Traditional IRA. However you may not be able to deduct the full amount of your personal IRA contributions from your taxes.

US residents, who are not American citizens but plan to stay in the US, can also open an IRA account. But they do need to show US earned income, a Social Security number, and qualify for the substantial presence test in the eyes of the IRS.

ℹ️ A Spousal IRA can be a form of a Traditional IRA that is owned by a non-working spouse.

US citizens will need to provide proof of employment, a Social Security number and bank details when opening a Traditional IRA account. You will also need to designate a beneficiary, or beneficiaries, to the account.

Alongside opening the Traditional IRA account, you will also need to decide how you would like the funds to grow in the account. Traditional IRAs can be held in a vehicle like a CD, or in bonds, mutual funds, ETFs or you can even buy individual stocks.

What you choose should be based on your timeline to retirement, risk tolerance, cash flow needs and other factors that a retirement planning professional can help you assess. Depending on your unique plan, you can find a Traditional IRA, and a firm to open it with, that is right for you.

Contributing to a Traditional IRA

There are specific rules to how much and how often you can contribute to a Traditional IRA. And it can change year by year.

For fiscal year 2020, the IRS allows:

  • $6,000 per year if you are 49 years old or younger
  • $7,000 per year if you are 50 years old or older

That is the most you can contribute and also deduct from your taxes for your IRA per year. The extra $1,000 you can contribute once you are 50 or older is an extra ‘catch-up’ bonus.

If you are also supporting a Spousal IRA, the same limits apply.

What happens if you put more than the limit in your Traditional IRA? You will be taxed at 6% for any amounts above the limit. To avoid the 6% tax, you must withdraw the excess funds by the date your individual tax return is due. That also includes any earnings on the excess amount.


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Traditional IRA Distributions

Eventually there will be a time when you can put all your retirement savings to use. So let’s take a look at how Traditional IRA distributions work.

Traditional IRAs have a stipulation for RMDs, or Required Minimum Distributions. This requires a certain amount of the money you have been saving in your account to be distributed to you. The RMDs must be taken by April 1 in the year after you turn 70 ½.

ℹ️ The SECURE Act from December 2019 allows individuals who turn 70 after July 1, 2019 to delay RMD withdrawals until age 72.

You are then required to withdraw your RMDs every year by Dec 31st of that year. And since you have not paid taxes on this amount yet, the RMDs will be taxed as income.

Your specific RMD amount will be based on the account balance you hold in the IRA and through the IRS’ Uniform Lifetime Table, which is based on life expectancy. You can always withdraw more than the RMD amount if you would like.

If in the case the owner of an account that is distributing RMDs passes away, the following year the RMDs will shift to the Uniform Lifetime Table for the beneficiary.

You can also read more about Inherited IRAs below.

ℹ️ If you don’t take your RMDs by the deadline every year, the amount not taken will be taxed at 50%

Early Withdrawals for Traditional IRAs

There are provisions to allow for early withdrawals from Traditional IRAs. So if you need money and find the savings in your IRA as a solution, you can withdraw money from the account at any time. But you will be taxed at your current income rate and if you are below the age of 59 ½, you will be taxed an additional 10% as a penalty.

But there are a few valid reasons for withdrawals that allow for an exception to the 10% penalty tax:

  • If you are above 59½
  • Disability
  • Qualified higher education expenses
  • First time homebuyers, up to $10,000
  • Qualified medical expenses
  • Active duty military service

For any of the above points, you can withdraw the money from your IRA without the 10% penalty.

Traditional IRAs vs. Other IRAs and 401 (k)s

Alongside a Traditional IRA, there are a few other avenues for retirement savings. Let’s take a look at how they differ from Traditional IRAs and when they are best fit to be used.

401(k)

A 401 (k) allows qualified employees to get a pre-tax deduction from their wages through payroll for retirement savings. The untaxed amount goes into the individual's 401(k) plan and the employer can look to contribute to the account or match the amount contributions.

Contributing to a 401(k) can reduce your tax liability now while also helping you save for retirement. Similar to a Traditional IRA, you will have to pay taxes on the money when you take it as income. 401(k) plans can also be rolled over into a Traditional IRA.

Roth IRAs

Roth IRAs allow individuals and married couples who earn below a threshold to use post-tax dollars to fund an IRA. A Roth IRA operates similar to a Traditional IRA in the sense you can invest the funds. But the major difference is that since it uses post-tax dollars, you won’t have to pay taxes on the income in retirement. You also do not need to take RMDs.

For those that fall above the income threshold, they can enter into a Roth IRA through what is called a Backdoor Roth IRA. It requires opening a Traditional IRA, since there are no income restrictions, and then rolling it into a Roth IRA. This does create a taxable event in the present however.

Spousal IRAs

Spousal IRAs are an option for married couples that have one spouse non-working spouse. Since a Traditional IRA requires employment for funding, a Spousal IRA gets around this by allowing the working spouse to fund a non-working spouse’s IRA. The Spousal IRA is however owned by the non-working spouse.

The Spousal IRA otherwise operates like a regular Traditional IRA, although it can come in the form of a Roth IRA too. Spousal IRAs help non-working spouses have their own retirement assets and tax savings for the future.

Inherited IRAs

As the name suggests, an Inherited IRA is a Traditional IRA account that is inherited upon the original owner’s passing. The beneficiary or beneficiaries then ‘inherit’ the IRA.

If a spouse is the sole beneficiary of the IRA then they can take it over and become the owner of the account. But if the IRA is inherited across multiple beneficiaries or non-spouse individuals, then each beneficiary is required to take their share of the assets. Each portion of the assets can be rolled into the beneficiary’s specified Inherited IRA account.

SEP

SEP stands for Simplified Employee Pension Plan. SEP IRAs let employers, and even the self-employed, open and contribute to SEP IRA accounts for their employees or themselves. The employer or business can be of any size.

To be a qualified employee to participate in a SEP, you must be:

  • At least 21 years old
  • Have been working at the business for 3 years or more
  • Received at least $650 in compensation, for 2021

As an employer or business owner, there are annual limits for how much you can contribute to an employee’s SEP IRA.

SIMPLE

SIMPLE is an acronym of Savings Incentive Match Plan for Employees. It allows for employers and employees to contribute to a Traditional IRA through the workplace. It is suited for employers that don’t already sponsor retirement plans.

A self employed individual can open a SIMPLE plan too.

To qualify for a SIMPLE IRA, the employee or the self-employed individual must:

  • Have earned at least $5,000 in compensation anytime during the last two years from the employer
  • Expects to receive $5,000 in compensation during the current calendar year

You can open a SIMPLE plan at any financial institution that offers them.


Sources


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