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(Traditional) IRA For Dummies: When Is It The Right Choice?

Tom
June 10, 2020

What is a Traditional IRA?

A Traditional IRA is a retirement account that allows an individual (the “I” in IRA) to set aside tax-deferred income for retirement. The entire contribution and earnings on those contributions are taxed at normal income tax rates when they are withdrawn during retirement.

Note: Did you know you can rollover your IRA to gold? Learn more here.

Traditional IRA Rules

There are three main categories of Traditional IRA rules. They dictate whether or not you can contribute, if you can deduct your contribution from your taxes, and what happens when you withdraw funds from the IRA.

Related Topic: Why I Chose to Rollover to a Gold IRA

Earned Income Rule

To contribute to a Traditional IRA you must have earned income. There are rules that allow spouses with unequal income to contribute to their own IRAs as long as they earn enough income to cover their contributions.

Also, you cannot contribute to a Traditional IRA after your reach age 70 and 1/2.

Deduction Limit Rules

Traditional IRA contributions are usually tax deductible from your income tax for the year of the contribution. However, the rules are based on your filing status and whether you were covered by a retirement plan at work.

Here's what this ends up looking like.

Traditional IRA Deduction If Covered By Retirement Plan at Work

[table id=11 /]

Traditional IRA Deduction If Not Covered By Retirement Plan at Work

[table id=12 /]

Withdrawal Rules

Unlike a Roth IRA, a Traditional IRA's contributed funds cannot be withdrawn without a penalty before age 59 and 1/2. Both contributions and earnings on top of those contributions are locked into the IRA until that age.

Withdrawing funds before that point will result in a 10% early withdrawal penalty on top of regular income tax. This takes a huge chunk of your withdrawal: if you're in the 25% tax bracket you end up losing 35% of your withdrawal.

There are some exceptions to the early withdrawal penalty, namely:

  • You are totally and permanently disabled. 
  • Your beneficiaries are withdrawing from the IRA after your death.
  • Your withdrawals are not more than the cost of your medical insurance while unemployed.
  • You are using the funds to build your first home.
  • You are paying an IRS levy.
  • You have medical expenses greater than 10% of your income.
  • Your withdrawals are not more than the cost of your higher education expenses for the year.
  • You are receiving the distributions in the form of an annuity.
  • Your distribution is a qualified reservist distribution.

These rules are in place to discourage you from withdrawing from your Traditional IRA quickly; it should be used as a last resort so the funds have time to continue to grow until your retirement.

Traditional IRA Contribution Limits

All retirement accounts have limits on how much money can be contributed each year. The contribution limit on Traditional IRAs currently sits at $5,500. Individuals age 50 or older can contribute an additional $1,000 per year as a “catch up” contribution for a total of $6,500 per year.

This means couples under age 50 can contribute up to $11,000 per year, couples with one spouse age 50 or older may contribute $12,000 per year, and couples over age 50 may contribute $13,000 per year.

Assuming you meet the deductible rules above you'll be saving a huge chunk on your income taxes every year you max out your contribution. Sitting in the 25% bracket with an $11,000 contribution lowers your tax due by $2,750.

Traditional IRA Fees

There are no IRS rules about fees for Traditional IRAs. You open a Traditional IRA at a brokerage firm (either online or in person); the company's fee structure dictates whether or not there are fees associated with the account.

Generally speaking it is easy to find a good broker that won't charge you an account maintenance fee, account setup fee, or any other miscellaneous fees for simply having an account. Brokerages that want to charge you for having an IRA better be able to show a lot of value as to why those fees are worth it when there are so many fee-free options available.

The only other fees you will pay with a Traditional IRA are:

  • Mutual fund expense ratio fees
  • Stock, bond, ETF, and mutual fund trading commissions
  • Account closure fee

Most brokers charge a fee if you close the account. The amount ranges, but typically is between $50 and $100. Thankfully most brokerage firms offer a sign-up bonus or the option to refund your closure fee at the brokerage firm you are leaving to come do business with them.

Traditional IRA Calculator

Benefits of Traditional IRA

Traditional IRAs are a great retirement option. Their overall benefit depends on your tax rate now and in retirement. If you are a high income earner now but still meet the deduction requirements laid out above, you can shave down your tax due each year using a Traditional IRA. Every dollar contributed could save you 25%, 28%, 33% or more.

This is especially beneficial if you can deduct a high tax rate today and pay a low tax rate in retirement when withdrawing the funds. Traditional IRAs are funded with tax-deductible funds, so they are taxed at the regular rate in retirement. Avoiding paying 28% income tax today to end up paying 25% in the future is a win with your taxes.

Traditional IRAs (and Roth IRAs, too) don't have the highest contribution limit compared to other retirement account options. Yet a couple that begins maxing out their contributions at age 27, continues to do so for 40 years until retirement age at 67, and generates a return of 8% per year will end up with $3,077,602.71 at retirement. Assuming a 25% income tax hit on those funds and they're still sitting on $2,308,202.03.

The tax write-off makes using a Traditional IRA a little bit easier to swallow than a Roth IRA. Roth IRAs are funded with post-tax income, so you're investing the money that comes on your paycheck. With a Traditional IRA you lower your income level before taxes, which makes the hit to your day-to-day bottom line sting a little bit less.

How to Open a Traditional IRA

Opening any retirement account is pretty simple thanks to the internet. With a Traditional IRA you must first identify what types of investments you want to hold. Are you a pure buy-and-hold index investor?

Then a simple account at Vanguard will do just fine. Are you looking to invest in precious metals, trade often, or do other complicated investment ventures? You're going to need a more advanced broker.

Do a search online for brokers to compare them based on the criteria that are important to you. Once you've identified one you can begin the application process online.

This included providing your name, address, Social Security number (to verify your identity to make sure you're not opening an account in someone else's name), and a government issued ID. Many times the paperwork will be mailed to you to physically sign and mail back while still allowing you to open the account today.

Once your account is setup and funded, you select your investments and begin your investment strategy.

Conclusion

Traditional IRA's are a great retirement vehicle, but the simple fact is that they aren't for most retirees. They don't offer much diversification or flexibility, which is critical when it comes to retirement savings. One retirement plan that I personally recommend to most individuals saving for retirement is transferring their current accounts over to a self-directed IRA. It offers the diversification that you need as you can have precious metals and real estate inside your retirement plan.

What type of retirement plan do you currently have?

About the author 

Tom

Tom is a former accountant turned entrepreneur. He is not a financial adviser but does tend to give a lot of financial advice to his friends and colleagues. He currently runs a small online venture and blogs about his research and experiences.

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