An Overview of the Traditional IRA
A Traditional IRA is an ‘individual retirement arrangement’ (IRA) that is designed as a retirement investment. Traditional IRA accounts are held at custodian institutions for the benefit of the investor, such as a bank or brokerage institution. Many investors are attracted to the Traditional IRA as some individuals are eligible for tax deductions for the amounts contributed. There are contribution limitations and income limitations for annual contributions, so it is important to determine eligibility by checking with the IRS or investment professional prior to making any investment decisions.
In addition to annual restrictions on the contributions, there are more restrictions with a Traditional IRA than a Roth IRA with regards to withdrawals. Unlike the Roth IRA, there are required mandatory distributions at the age of 70½. Also, unlike the Roth IRA which offers the ability to take withdrawals on the principal contributed prior to the age of 59½, any withdrawals from a Traditional IRA prior to this age will be taxed and have an early withdrawal penalty of 10%.
There are several advantages of saving into a Traditional IRA, including:
- The contributions to a Traditional IRA are often tax deductible, working to lower the investor’s total annual taxable income. This tax benefit is immediately realized, in contrast with the Roth IRA that will not show tax benefits until withdrawal after the age of 59½. For many, the ability to immediately reap the benefits of these tax savings overshadows the potential tax benefits of a Roth IRA.
- For investor’s who believe that they are going to reduce their annual tax bracket in retirement, the Traditional IRA offers additional benefits over the Roth IRA.
- New rules allow eligible investors to convert their Traditional IRA accounts into Roth IRA accounts. For some, this can offer long term tax benefits.
Some disadvantages of the Traditional IRA include:
- There are income eligibility requirements for the ability to deduct contributions into a Traditional IRA on a regular basis. These requirements can often be low, so it is important to review them prior to making contributions to a Traditional IRA.
- Withdrawals from a Traditional IRA are treated as ordinary income tax and can substantially increase an investor’s taxes if the amount inside of the Traditional IRA account is substantial. It is advised to have an expert work with an investor to determine the amounts that should be withdrawn annually in order to reduce the overall tax liability due annually.
- Traditional IRA’s are subject to a mandatory withdrawal rule, meaning that investor’s must start taking withdrawals from their accounts after the age of 70½. If proper planning did not take place, these mandatory withdrawals may raise the investor’s annual income tax bracket.
- If an investor makes early withdrawals from this account prior to the age of 59½, there is a 10% early withdrawal penalty imposed in addition to the federal income taxes that would also be assessed on the amount withdrawn.