While a traditional IRA comes with a lot of benefits such as deductible contributions, tax-deferred growth, and a great variety of investments, there are also traditional IRA disadvantages you need to know before you open an account. The traditional IRA drawbacks include but are not limited to lower contribution limits compared to employer-sponsored plans such as 401(k) plans, tax on distributions, RMD requirements, and ineligibility for tax deduction for higher income earners due to income phase-out ranges imposed by the IRS.
If you are new to retirement savings, you need to know these advantages in detail as they affect your retirement savings and financial goals.
Here are traditional IRA disadvantages you should know before you commit to opening an account.
What is a traditional IRA?
A traditional IRA is an individual retirement account(IRA) you can open at your local bank, credit union, or online brokerage firm and investment companies with retirement services. Contributions to the traditional IRA may be tax-deductible depending on your filing status, income level, and other benefits you have from work such as pre-tax 401(k).
The traditional IRA is similar to the Roth IRA but for the Roth account, you make contributions with after-tax wages. For 2024, the contribution limits to a traditional IRA are $7,000 or $8,000 if you are 50 or older. Before you open an IRA, there are traditional IRA disadvantages you should know about.
Every retirement account comes with unique benefits and drawbacks. Knowing what to expect from the account is equally important. Knowing the traditional IRA disadvantages will help you make an educated decision before you open the account.
The following are the top 5 traditional IRA disadvantages you should know about.
1. Early withdrawal penalty
Saving for retirement means that the money in your account should stay in the account until you have reached retirement age. Many retirement accounts including traditional IRA require that you keep the money in the account until you have reached 59½.
If you withdraw money from your traditional IRA before turning 59½, you will pay a 10% penalty and taxes on all tax-deductible contributions. The 10% penalty may be waived if you meet the IRS exceptions.
2. Low contribution limits
When it comes to retirement savings, every dollar you contribute matters, and the more you contribute the better. Higher contributions allow you to grow your nest egg much faster and reach your retirement goals easily. One of the traditional IRA disadvantages you should know is that the account has low contribution limits compared to employer-sponsored plans such as pre-tax 401(k) plan or SIMPLE 401(k).
Every retirement plan comes with its limits. For the traditional IRA, the maximum contribution you can make to the account in 2024 is $7,000 or $8,000 for those who are 50 or older. For 2023, the contribution limits to a traditional IRA are $6,500 or $7,000 if you are 50 or older.
These contribution limits are the same for Roth IRAs.
Most employer-sponsored plans come with higher contribution limits than IRAs. For example, you can contribute up to $23,000 or $30,500 if you are 50 or older to a 401(k) plan in 2024. For 2023, the contribution limit to a 401(k) is $$22,500 or $30,000 if you are 50 or older.
3. All your contributions might not be tax-deductible
One of the traditional IRA disadvantages you need to know is that all of your contributions may not be deductible. Typically, eligibility for tax deduction depends on your modified AGI, filing status, and other benefits you have from work.
The following are income phase-out ranges to check your eligibility for tax deduction in 2024.
If you are filing single or head of household, you will have a full deduction when your modified adjusted gross income(MAGI) is under $77,000. When your MAGI is between $77,000 and $87,000, you will qualify for a partial deduction. If your modified AGI is higher than $78,000, you will not qualify for tax deductions.
On the other hand, if you are married and filing jointly, you will be eligible for a full deduction on your contribution when your MAGI is under $123,000. You will qualify for a partial deduction for modified AGI between $123,000 and $143,000. For income above $143,000, you will not qualify for deductions.
Finally, if you are married but filing separately, you will qualify for a partial deduction when your income is under $10,000. No deductions when your MAGI is equal to or over $10,000, under the same filing status.
4. Traditional IRA disadvantages: Taxable distributions
We cannot talk about traditional IRA disadvantages without mentioning taxes on your distributions. By default, this account is a tax-deferred account which means you delay paying taxes, grow your account, and pay taxes only when you are taking withdrawals.
Like any other tax-deferred retirement plan such as 401(k) plans and SIMPLE IRAs, you will pay applicable taxes on distributions from a traditional IRA. The tax you pay will depend on your tax bracket. Any non-deductible contribution you made to the account, however, will not be taxed. This is because those contributions were taxed already.
5. Traditional IRA requires RMDs when you turn 73
One of the traditional IRA disadvantages is that you must start taking required minimum distributions (RMDs) when you turn 73.
RMDs are mandatory distributions you must take from your account every year after turning 73. These distributions allow the IRS to collect taxes you did not pay. Failure to meet your RMDs requirements may result in a 50% tax penalty on the money you did not distribute on time.
Other accounts that require RMDs include 401(k) plans, 457(b), 403(b), SEPs, SIMPLE IRAs, traditional IRAs, etc.
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