What is a Traditional IRA & How Does it Work?

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Retirement can be a scary word, but not because we’re all getting closer to retirement age. It’s because most of us don’t know where our financial future will be, and that’s where the uncertainty comes in.

Investing in a retirement plan right now seems like an impossible feat, but it’s actually much more affordable than many people think. Your retirement account isn’t there to siphon the vast majority of your paycheck each week; it’s there to help it grow.

A traditional IRA is the solution to the future’s uncertainty, but there are some things you need to know about what they are, how they work, and how you can utilize them properly to put yourself at an advantage in the future.

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What is a Traditional IRA?

They’re retirement accounts that put you in control of how the money is used, where it’s invested, and how it impacts your future. These retirement accounts allow you to contribute tax-deferred dollars as you earn them through your employment so that you can contribute as much money as possible.

Upon retirement, you can withdraw these funds in increments much like a paycheck. Traditional IRAs accrue value over time, so your money can grow as you age and provide you with a comfortable way of living into your retirement years.

This retirement account invests your money, so you see a return that supersedes the initial money you put in. Depending on when you begin your IRA, even accounting for the current maximum deposits each year, you could retire with over $1 million before the age of 60 without having to have even put a quarter of that money in.

This also doesn’t include other retirement-friendly investments that you can make. A traditional IRA is the cornerstone of any serious portfolio with an emphasis on retirement.

How to Open a Traditional IRA

Here is a detailed, step-by-step instruction to open up your own traditional IRA account right now.

  1. Decide which financial institution you want to do business with (we have guides on many of them).
  2. Determine which IRA account type you want, whether traditional or Roth (more on that in a minute).
  3. Sign up through the respective institution portal and provide information to open your account.
  4. 4. Begin with an initial contribution to your IRA
  5. 5. Utilize the funds in your IRA and begin investing in various assets (index funds are usually the way to go).

When you contribute money, it’s technically post-tax dollars whether that’s received through a paycheck or self-employment. On your taxes, you'll fill in the necessary boxes on Form 1040A and receive a deduction to adjust your gross income, which may help you stay in a lower tax bracket and reduce your overall tax costs.

Is a Roth IRA Better than a Traditional IRA?

Both of these retirement accounts are excellent options, but operate entirely differently. Let’s look at a few major differences.

  • Tax-Deferred vs. Tax-Free: A traditional IRA uses pre-tax dollars that are adjusted to your gross income each year, but a Roth IRA only uses post-tax dollars. The good news? You don’t have to worry about taxes when you withdraw.
  • Penalty Restrictions: Traditional IRAs incur a penalty fee if you withdraw money early, typically around 10% or so. With a Roth IRA, there is no penalty for early withdrawal even if you aren’t 59 ½ (apart from taxes).
  • Growth Differences: A Roth IRA doesn’t grow the same way that a traditional IRA does because of the lax regulation and laws on it, but it does offer more flexibility if you need money for a non life-changing reason.

In short, Roth IRA accounts and traditional IRA accounts are very similar in the way that you save, but not in the capacity that you save. 

A Roth IRA is more forgiving than a traditional IRA when big life expenses come up, but if you’re smart, you can use a traditional IRA to completely negate the 10% early withdrawal penalty under special circumstances.

Both are great, it just depends on how you use them and how you invest in your retirement.

Should You Open a Traditional IRA?

Yes. Even if you aren’t able to contribute the full amount each year, the longer you have an IRA that you contribute to, the more money you will have when it comes time to retire.

While an IRA definitely helps against inflation, it grows faster than the average inflation rate, meaning your money grows to protect you and give you a more prosperous future.

Not everyone has a 401(k), but everyone should have an IRA. It’s self-directed, so you can manage it on your own regardless of your employer or status, and it will always be yours. 

You can also couple your traditional IRA with a 401(k) to maximize your retirement money when you get older.  If you do nothing else for your financial future today, at the very least you should open up an IRA account. 

The process is simple and can be done online, and the benefits are enormous. Having that level of financial security as you age will give you more peace of mind that you’ll know what to do with.

Next Steps

A traditional IRA is an excellent way to save for retirement starting right now. If you began investing in 2017 at the age of 29, you would contribute $165,000 pre-tax dollars over the course of thirty years, and end up with $555,902 by the age of retirement at 59 ½.

If you started at 18 and contribute until you’re 59 ½, that would be a contribution of $225,000 with a return of $1,262,977 by the age of retirement (based on figures and calculators from 2017).

The earlier you get started, the better off you’ll be when it comes to retirement. A traditional IRA is a solid and relatively inexpensive plan for the future, and there’s no reason that you shouldn’t get started on one as soon as possible.

There’s no penalty for contributing your annual limit in one lump sum, just be sure you know the ins and outs of how these work before you go full steam ahead.

Traditional IRA FAQ's

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2 thoughts on “What is a Traditional IRA & How Does it Work?”

  1. I have a question. What are the rules for making a gift to my son from my IRA? Is this beneficial tax wise?

  2. Hello Mike
    You can give part of your IRA to your son. The taxes you pay depend on the type of IRA you have.
    The tax rules for a Roth and a Traditional IRA are different.
    The Roth IRA is funded with money you’ve earned and already payed taxes on and the withdrawals (including gifting) are tax free.
    The traditional IRA is funded with pre-tax dollars, so you still have to pay taxes on withdrawals which includes gifting.
    Thank you for visiting us!

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