A Traditional IRA is a type of Individual Retirement Account that has been available to Americans since 1975. In recent years, Traditional IRAs have lost ground in popularity due to Roth IRAs since qualified Roth IRA withdrawals made during retirement are tax-free.
Traditional IRA Basics
Traditional IRAs are retirement savings accounts to which limited contributions can be made throughout the tax year. Any contributions made to your Traditional IRA are tax deductible, but when you reach the retirement age (59½) and begin making withdrawals, those are treated as normal taxable income.
Like most IRAs, Traditional IRAs are normally flexible in terms of the investment vehicles that can be utilized within the account, depending on the custodian (broker or bank) that holds the account. Investors typically contribute to their Traditional IRA in the form of securities such as stocks or mutual funds, but other investments are also possible, like CDs, bonds, derivatives, and other products.
Traditional IRA Advantages and Disadvantages
The biggest draw of Traditional IRAs over other retirement accounts is their tax-advantaged status on the front end (when contributions are made). Contributions made to a Traditional IRA are tax deductible, so you lower your modified adjusted gross income (MAGI) by contributing.
The drawbacks of Traditional IRAs include taxation on the back end (when you make withdrawals during retirement), mandatory withdrawal guidelines, and lower income limits for contribution.
Traditional IRAs vs. Roth IRAs
The most important difference between Roth IRAs and Traditional IRAs is the way invested money is taxed. Withdrawls from Roth IRAs are generally not taxed (as long as the withdrawal requirements are met), while Traditional IRA withdrawls are treated as regular taxable income.
Traditional IRA Contributions
Unlike Roth IRAs, contributions made to a Traditional IRA are tax deductable. These tax deductions are the main draw to Traditional IRAs.
The maximum amount a taxpayer can contribute to his or her Traditional IRA each tax year is determined by age and taxable compensation. For tax year 2014, taxpayers under the age of 50 could contribute $5,500 to their Traditional IRA. Those 50 or older could contribute a maximum of $6,500.
Those contribution limits are expected to rise by $500 per year, depending on the rate of inflation.
Traditional IRA Eligibility
Taxpayers must meet certain requirements in order to be considered eligible to contribute to a Traditional IRA. These requirements are based on the Modified Adjusted Gross Income (MAGI) of the contributor(s), which includes all wages, tips, salaries, bonuses and professional fees. Those that earn below a certain threshold are eligible for the full contribution amount, while those that earn more than the limit are either allowed partial contributions, or none at all. Here are the 2014 MAGI guidelines for Traditional IRAs:
- Single filers: Maximum contribution allowed if MAGI is below $60,000. Partial contributions allowed up to $70,000. Taxpayers with a MAGI over $70,000 are not eligible to contribute at all.
- Joint filers: Maximum contribution is allowed if combined MAGI is below $96,000. Partial contributions are allowed up to $116,000. Over $116,000 are not eligible to contribute.
- Married filing separately (as long as the couple lived together during any part of the year): $0 for full contribution, $0 to $10,000 for a partial contribution. Those with MAGI over $10,000 are not allowed to contribute.
401k and 403b Exclusivity
Money you contribute to an employer’s 401k or 403b plan does not affect your ability to contribute to a Traditional IRA. Thus, your contribution limits are the same regardless of your other employer-sponsored retirement plans.
Opening a Traditional IRA Account
You can open a Traditional IRA account with nearly any major brokerage. Once opened, you may begin contributing to it or you can “roll over” funds from other types of accounts (such as 401ks). The funds you roll over into your Traditional IRA do not affect your contribution limits for that tax year. Note that there may be special tax considerations when you combine rollover assets with new contributions.