A traditional IRA is a type of retirement savings account where your contributions might be tax deductible. You can open a traditional IRA from your local bank or online investment firms and brokerage companies. With a traditional IRA, you grow the account on a tax-deferred basis and pay income tax on your distributions during retirement.
Another IRA you should know about that is similar to a traditional IRA is a Roth IRA. The only difference between both accounts is that contributions to a Roth IRA come from after-tax wages and you pay no income tax on your withdrawals during retirement.
Here is everything you need to know about the traditional IRA.
What is a traditional IRA?
A traditional IRA is a retirement account that you can open from a local bank or online brokerage company. Unlike a Roth IRA where contributions are not deductible, contributions to a traditional IRA might be tax-deductible. According to the Internal Revenue Service (IRS), the amount you can deduct from a traditional IRA will depend on your income, filing status, and other tax-advantaged benefits you have from work.
With a traditional IRA, you grow the account on a tax-deferred basis and pay applicable taxes when taking distributions during retirement. Unlike a 401(k) plan that is sponsored and managed for you, you must open a traditional IRA and manage it yourself. Once the account is open, you can buy investments of your choice including mutual funds, index funds, bonds, individual stocks, etc.
The difference between traditional IRA and Roth IRA
The traditional IRA and Roth IRA are two popular individual retirement accounts you can choose from. Both accounts offer tax benefits and can be opened at a bank, online broker, and investment firms with retirement services. The biggest difference between a traditional IRA and a Roth IRA is when tax benefits are realized.
If you have a traditional IRA, your contributions might be tax deductible, you will grow your account on a tax-deferred basis, and pay tax tax on your distributions. The traditional IRA also comes with required minimum distributions(RMDs) when you turn 73.
The Roth IRA does not give you upfront tax benefits as your contributions come from after-tax wages. But, you will grow your account tax-free and pay no income tax on your distributions during retirement. Unlike traditional IRAs that require RMDs, the Roth IRA does not require RMD and you can pass it on to your descendants tax-free.
More details: Traditional IRA vs Roth IRA: What is the difference?
Traditional IRA vs. 401(K)
Both 401(K) and traditional IRAs offer direct tax benefits. The biggest difference between both accounts is about how much you can contribute, tax deductions, and how accounts are created and funded.
The 401(k) plan is offered through your employer while the traditional IRA is opened by individuals themselves at a bank or brokerage company. That is if your company does not offer retirement benefits, you cannot open a 401(K) yourself. But, you can open a traditional IRA at any time.
With a 401(k) plan, you might get a match from your employer. For the traditional IRA, on the other hand, you don’t get any match as the account is not sponsored by employers. Both accounts apply income tax on your distributions and require RMDs when you turn 73.
When it comes to contribution limits, however, the 401(k) comes with much higher contribution limits compared to traditional IRAs. For 2024, you can contribute $23,000 to your 401(k) while the maximum contribution you can make to a traditional IRA is $7,000. If you are 50 or older, the contribution limits become $30,500 for the 401(k) plan and $8,000 for the traditional IRA.
Details: 401(K) Vs Traditional IRA: What is the difference?
Traditional IRA contribution limits in 2024
The traditional IRA contribution limits in 2024 are $7,000. If you are 50 or older, you can contribute up to $8,000 to a traditional IRA in 2024. For 2023, the maximum contributions to a traditional IRA are $6,500 or $7,500 if you are 50 or older.
Traditional IRA required minimum distributions (RMDs)
The traditional IRA is one of many accounts that come with RMDs. Required minimum distributions are mandatory withdrawals you must take each year when you turn 73. Failure to make these distributions on time will result in a 50% penalty on the money you did not take out on time.
Early withdrawal penalty
Typically, a 10% penalty is applied to your withdrawals when you take money from a traditional IRA before turning 59 ½. In addition to the penalty, you also pay applicable tax on your withdrawals.
There are exceptions to this rule and you can learn more about them by checking out the IRS exceptions.
Pros and cons of traditional IRA
No retirement account is perfect. Each account has its benefits and drawbacks. The following are the benefits of a traditional IRA.
Pros of traditional IRA
- Tax-deferred account growth and investments
- Fewer fees compared to the 401(K) plan
- You will have a wider range of investments
- The account will reduce your taxable income
Disadvantage of traditional IRA
- Some or all of your contributions may not be deductible
- You pay tax on deductible contributions you made on the account
- Low contribution limits
- The account comes with an Early withdrawal penalty
- Traditional IRA come with RMDs when you turn 73
Where to invest your traditional IRA money?
Traditional IRAs come with a wide range of investment varieties. The best way to invest your IRA money is to buy a mixture of stocks, bonds, mutual funds, exchange-traded funds (ETFs), and bonds. This strategy allows you to maximize your return on investment without exposing your hard-earned money to excessive risks.
More retirement tips
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