Traditional IRA Definition
Traditional IRA stands for an Individual Retirement Account that works as an account to help individuals save taxes and grow their income for retirement plans. They are a preferred choice owing to certain tax benefits allowed on the investments made with the funds in the account.
- Traditional IRA refers to a type of Individual Retirement Account in which individuals contribute a portion of their yearly income as part of their retirement planning. Contributions can avail tax deductions if qualified.
- The investments made using the fund in the account are not taxed until you withdraw the money from the account upon retirement, i.e. 59 ½.
- In 2021, individuals who are younger than 50 can contribute up to $6000 every year, and if they are 50 or above, they can contribute a maximum of $7000.
- If you withdraw the money before you turn 59 ½, you will be charged with a penalty of 10%. There are certain exceptions to this rule, like purchasing your own home, certain medical bills, college fees, etc.
- Generally, the income earned from the investment will not be taxed until its withdrawal upon reaching your retirement. Also, the contributions made to the account can fetch full or partial tax deductions depending on your income and marital status.
How Does Traditional IRA Work?
Let us take you through an example first before getting into the details of the Traditional IRAs.
- Suppose I am ten and my sister is six. My father started giving me $12000 every year but asked to share 25% of it with my sister. I wanted to save some for the rainy days, irrespective of my love for my sister. So, I told her that dad only gave me $10000 every year.
- Meanwhile, I started putting the extra $2000 in a safe with my mother. I promised her I wouldn’t touch the money until I turn 20. She said if I successfully pull this off for the next ten years, she will reward me with some extra money at the end of it.
- I kept my word, and when I turned 20, my mother kept hers. $2000 for ten years became $20000 while an additional 50% from my mother brought it up to $30000. Just as I was about to take the money, my sister saw us and demanded that I share some of it with hers. We argued, but at last, agreed to give her 25% of $30000 that is $7500.
- It left me with $22500.
- Initially sad, but I did a little math later on. I realized that if I had been giving 25% of $12000 every year from the start itself, I would have wounded up giving more than what I paid just now. So, it was a smart decision, indeed!
Also, this is how a traditional IRA account works.
- My father is my employer.
- $12000 is my salary.
- My sister is the federal government; 25% of what I gave her is the annual income tax I paid every year.
- My safe was my IRA, in which I kept saving a part of my salary every year.
- My mother is the stock and bonds in which I invested and earned $10000.
- $7500, which I gave to my sister (government), is the tax deducted on my earnings from the investment made from the money in my safe, i.e. the traditional IRA.
- The real deal is surrounded by regulations, policies, eligibilities, penalties, limitations, and tax brackets that constantly change. As such, open an account after being thorough with the implications.
Features of a Traditional IRA
- A traditional IRA allows you to contribute a part of your yearly income into an account, as explained above.
- Traditional IRAs can be opened at banks, credit unions, or by taking the services of a stockbroker.
- Other than your income, you can also benefit from transferring the amount from 401(k) or any other retirement account to your traditional IRA.
- The contributed amount to the traditional IRA can be subjected to tax benefits and tax deduction depending on certain factors. If eligible, the traditional IRA account allows tax deductions on the contributions made in a year. You will not have to pay taxes on them until you retire, i.e. until you reach 59½.
- Upon retirement, the withdrawals will attract taxes based on the tax bracket your income falls in.
- If one dies before 59 ½, the IRA money will be received by the beneficiary.
- The contributed amount can be invested in stocks, bonds, and other investment vehicles. They will attract tax-deferred growth. i.e. the income earned from investments won’t be tax until withdrawal upon retirement.
- There are four different types of Individual Retirement Accounts – Traditional, Roth, SEP, and Simple.
Traditional IRA Limits
- The requirement that the contributed amount should be the income earned in a year is one of the essential traditional IRA income limits.
- The traditional IRA contribution limits for 2021 are the following. You can add up to $6000 if you are less than 50. If 50+, you can contribute $1000 extra, i.e. $7000 in your IRA.
- Generally, if you withdraw money from the account before turning 59½, you will need to pay a 10% additional tax on the withdrawal. There are exceptions to this rule if the money is used for unreimbursed medical bills, disability, higher education, etc.
- If you do not start withdrawing money from the account after a certain age, usually 72, you’d be taxed on it.
- Any excess contributions in a year are taxed at 6% per year.
- You may choose to invest in both the IRAs, traditional and Roth, at the same time, but you will be charged with a penalty of 6% if you exceed the total amount permitted in a year.
Eligibility of Traditional IRA
The eligibility and tax policies keep on changing with time and due to the amendments by the IRS. The primary eligibility criteria are as follows.
- Anyone can open an account.
- Having an earned income is a necessary aspect of being eligible for contributing to an IRA.
- You and your spouse can jointly file for an IRA as a married couple. The contribution limit here under the traditional IRA is up to $11000.
Traditional IRA and Tax
The tax rules and reliefs often change frequently in a financial year. IRS had announced tax reliefs for IRA 2021 for the victims of the winter storms in Texas. The amount contributed to the IRA may be eligible for tax deductions under your individual federal income tax return, depending on whether you have enrolled in a retirement plan at work. The traditional IRA income limits will also determine if you are eligible for tax deductions.
#1 – Enrolled in a retirement plan at work: The deductions may be partial or non-deductible if –
- If you are married and your spouse or you yourself are a part of a retirement scheme plan which is employer-sponsored like 401 (k),
- And if your income goes beyond certain levels. You can refer to the deduction limits here.
#2 – Not enrolled in a workplace retirement plan: You will be allowed full deductions if you or your spouse (in case you are married) are not enrolled in an employer-sponsored retirement plan. You can refer to the deduction limits here.
In case your contributions become non-deductible, do not forget to use Form 8606 to report them, so you do not have to pay the tax again at the time of withdrawal. Issues such as contributions becoming non-deductible often give rise to traditional IRA vs Roth IRA debates. Individual Retirement Account is a well-devised saving plan for retirement days, but you will need to ascertain if it is right for you or not. If your contributions are becoming non-deductible, exploring other options as well should be considered.
This has been a guide to What is Traditional IRA & its definition. Here we discuss how it works along with features, income and contribution limit, eligibility, etc. You may also have a look at the following articles to learn more –