Retirement saving is one of the fastest ways to build wealth due to the unique tax benefits you get from retirement accounts. If you are planning to open an IRA, a traditional IRA might be the best choice especially if you don’t have other retirement coverage such as a pre-tax 401(k) from your work. In this article, I will walk you through the pros and cons of a traditional IRA and what you should expect after opening the account.
What is a traditional IRA and how does it work?
A traditional IRA is an individual retirement account that allows you to make before-tax contributions toward retirement savings. With a traditional IRA, you get to grow your account on a tax-deferred basis and pay taxes on your distributions during retirement. This account is a good supplement to your 401(k) plan.
You can open a traditional IRA from a local bank, brokerage firm, or investment company with retirement services. The traditional IRA comes with a variety of investments which include mutual funds, index funds, bonds, individual stocks, and money management accounts. Just like other tax-deferred plans such as 401(k) plans and SIMPLE IRAs, the traditional IRA comes with required minimum distributions(RMDs) once you turn 73. Failure to take RMDs can result in a 50% tax penalty on the amount you did not distribute on time.
If you are interested in opening an IRA, there are pros and cons of a traditional IRA you should know before you make a final decision.
What are the pros and cons of traditional IRAs?
Every retirement account has its benefits and drawbacks and they differ from one account to another. The biggest benefit you should expect when you open a traditional IRA is tax benefits. Tax benefits dictate the retirement account you pick and how fast you can reach your retirement goals.
Before you enjoy traditional IRA tax benefits, there are pros and cons of traditional IRA you should know about. To make smart choices with your money and reach your retirement savings goals faster, you need to educate yourself about your retirement accounts.
The following are the pros and cons of a traditional IRA you need to know.
Pros of traditional IRA
Although there are pros and cons of a traditional IRA, its pros may outweigh its cons depending on your situation. The following are the top 5 pros of traditional IRA you should know.
1. You grow your account on a tax-deferred basis
Contributions you make to a traditional IRA may be tax-deductible depending on your modified adjusted gross income (MAGI), filing status, and other benefits you get from work. You will then grow the account on a tax-deferred basis and pay applicable tax during retirement.
Tax-deferred means your earnings are not taxed until you are taking distributions. By delaying taxes on your earnings, your retirement savings grow faster due to compounding effects on your account.
2. Contributions may reduce your taxable income
Stashing away before-tax money directly reduces your taxable income. Although, contributions to a traditional IRA will not be as much as you can contribute to your 401(k), every little bit helps. Assuming that you qualify for the traditional IRA full deduction, you can stash away up to $7,000 or $8,000 if you are 50 or older in 2024. This will directly reduce your taxable income by the same amount.
For example, let’s assume that you made $60,000 and you are single. With this income, you will qualify for a full deduction on your traditional IRA even if you are covered by a 401(k) plan from work. If you make a full contribution to your account and you are under 50, your remaining income after contributions will be $53,000. This means that only $53,000 of your income will be taxed instead of $60,000. Since your taxable income is now lower, the amount you will owe in taxes will be lower as well.
3. Traditional IRA comes with the investment flexibility
Unlike the 401(k) plan where you are restricted to investment options inside the account; the traditional IRA comes with a wider range of investments. With this account, you can invest in individual stocks, bonds, index funds, mutual funds, Exchange Traded Funds(ETFs), and much more.
4. Fees are lower compared to 401(k) plans
Due to high competition among providers, individual retirement accounts come with relatively much lower fees compared to employer-sponsored plans such as 401(k) fees. Investment fees are usually affected by the types of investments you put in your portfolio. For example, passively managed funds tend to charge fewer fees compared to actively managed funds.
5. It is easy to open and manage a traditional IRA
Due to the availability of the internet, most companies allow you to open an account online and manage your investments remotely. You don’t have to walk into some company’s office to create an IRA. Everything can be done in a matter of minutes from your laptop.
The traditional IRA is one of those accounts that can be opened online. Most providers will approve your account faster but others could require extra documentation for identity verification. Some information you should expect to provide include, but are not limited to your full name, address (residence and mailing), social security number, photo ID, proof of employment, beneficiary information, etc.
Traditional IRA disadvantages
Before you open a traditional IRA, there are drawbacks to a traditional IRA you should know. Here are the top 5 traditional IRA cons you should know about.
1. Low contribution limits
One of the biggest drawbacks of traditional IRAs is low contribution limits. In 2024, you can contribute up to $7,000 or $8,000 if you are 50 or older. The Roth IRA has the same contribution limits for the same year. These contribution limits are much lower compared to what contribution limits on employer-sponsored plans such as 401(k) plans.
For example, if you have a 401(k) plan, you can contribute up to $23,000 or $30,500 if you are 50 or older. In addition, you may get an employer match to the account which is free money.
2. You must start taking RMDs when you turn 72
One of the biggest disadvantages of traditional IRA is RMD requirements. All tax-deferred retirement plans come with RMDs when you turn 73. RMDs or minimum required distributions are mandatory withdrawals you must take from your account every year after reaching a certain age. RMDs are imposed by the IRS to recover deferred taxes on your contributions.
Failure to take RMDs may result in a 50% tax penalty on the amount you did not distribute on time. For example, if you were supposed to take out $2,500 but only took out $2,000, you may end up with a $250 tax liability on the $500 you did not take out on time. Other plans that require RMDs include some of the following: IRAs-based accounts, 401(k) plans, 503(b), 457(k), etc.
3. All your contributions might not be tax-deductible
Even if you will grow your traditional IRA on a tax-deferred basis, all your contributions may not be tax-deductible. There are no income limits to making contributions to a traditional IRA. However, the amount you can deduct will depend on your modified adjusted gross income (MAGI or modified AGI), your filing status, and other benefits you have from work.
Traditional IRA phase-out ranges if you are covered by other plans from work
- If you are flinging single or head of household, you will qualify for a full deduction when your MAGI is less or equal to $77,000. If your modified AGI is between $77,000 and $87,000, you will qualify for a partial deduction. You will not qualify for a tax deduction for income over $87,000 under these conditions.
- If you are married and filing jointly and your modified AGI is equal to or less than $123,000, you will qualify for a full deduction. An income between $123,000 and $143,000 will get you a partial deduction. You will not be eligible for deductions if your income is equal to or higher than $123,000.
- On the other hand, if you are married but filing separately and your modified AGI is under $10,000, you will qualify for a partial deduction. Otherwise, you will not qualify for deductions for income equal to or over $10,000 under the same filing conditions.
4. You will pay a 10% early withdrawal penalty
Contributing to traditional IRA and other retirement plans is like a contract you sign with the IRS. By saving money for retirement, the IRS allows you to delay paying taxes, invest your money without paying taxes on your returns, and pay taxes on your distributions.
In return, you agree to leave the money in the account until you have reached the retirement age approved by the IRS which is 59½, in most cases.
The problem is that life does not follow a straight line and you cannot anticipate every event in your life. So, there are times when you may end up violating these terms and take the money out before you turn 59½. Hence, triggering a penalty.
Early withdrawals from your traditional IRA will come with a 10% penalty and taxes on your distributions. So, whatever you do, you must be aware of this rule and make calculated decisions.
5. Distributions from traditional IRA are taxable
To recover its share, the IRS imposes RMDs on your account when you turn 73. The IRS uses RMD to collect tax you did not pay on your contributions.
Non-deductible contributions to traditional IRAs will not be taxed. This is because you would have paid taxes on those contributions.
