So What's a Traditional IRA Anyway?
Updated: Oct 5, 2020
You've may have heard that you can not only save for retirement and invest, but save on taxes too if you have a Traditional IRA. But what is a Traditional IRA? Well keep on reading to find out!
If you haven't read it yet, checkout our post on IRA basics. It gives you an easy to understand overview of what an IRA is and how you can use one to build wealth.
So What is a Traditional IRA?
In short, a Traditional IRA is a tax deferred retirement account in which you, as the account holder, can make "pre-tax" contributions, saving you on income taxes today. Your contributions (investments) will then grow tax free until you are ready to withdraw from the account. You would then pay taxes on the amount you withdraw, based on your income tax rate at the time of withdrawal, for both the contributions and any growth (earnings/gains).
Sounds great, what's the catch?
As with all U.S. retirement plans and accounts, there are rules around how much you can contribute, who can contribute, and when.
For 2020, the annual contribution limit for a Traditional IRA is $6,000. If you are 50 or older, the IRS allows an additional $1,000, making it a maximum contribution of $7,000.
Who Can Contribute:
As with all IRAs, the IRS requires that any individual contributing to an IRA (Traditional or otherwise) must have earned income (e.g. W-2 income, contractor, tips, etc…) equal to or greater than their contribution amount.
That means that if you want to contribute $6,000 to an IRA in 2020, you must have at least $6,000 in earned income reported on your 2020 tax return.
When You Can Contribute:
Also as with all IRAs, the contribution window for a given year runs from January 1st through Tax Day (typically April 15th) of the following year. That's right, 15 ½ months to save your tax-deferred heart out!
So do I always get a full tax deduction for my contributions?
For Traditional IRAs, rather than set a limit on who can contribute, the IRS sets a limit on who can receive a tax deduction from a Traditional IRA. Depending on your tax filing status, your modified adjusted gross income (MAGI) must be below a certain threshold to receive either the full or partial tax deduction.
Use the tables below to find your applicable tax filing status for 2020 and MAGI. In most cases, you can base your estimated MAGI off your previous year’s AGI (Adjusted Gross Income), found on line 8b of your 1040 Federal Tax Form.
If you are covered by a retirement plan at work, use this table to determine if your modified AGI affects the amount of your deduction.
If you are NOT covered by a retirement plan at work, use this table to determine if your modified AGI affects the amount of your deduction.
I already have a retirement account through my employer. Why do I need a Traditional IRA?
You may be familiar with other tax-deferred retirement accounts that are sponsored by your employer, like a 401K, 403b, or 457b. A Traditional IRA is similar, except it is typically self-directed, which means that you get to choose which provider/brokerage you want to use (just like how you chose which bank you open your checking account with!). With Traditional IRAs, you have complete control over which investment options and funds you want to invest in.
While we generally recommend investing in a low cost index fund that tracks the total stock market or S&P 500, with an IRA you can choose to purchase individual shares of any company that is publicly traded. Most employer-sponsored plans only allow investing in mutual/index funds.
Additionally, if you are lucky enough to be able to max out your employer-sponsored plan, and have some extra cash you want to invest, a Traditional IRA can be a great way to invest that money while still saving on taxes.
A Traditional IRA can also be a great vehicle for rolling over an old 401K. Many 401Ks from former employers will start charging maintenance fees once you leave your employer, or worse, your money is sitting in some high fee, low return fund losing you money every day. Don't let your hard earned money get eaten up by fees and underperforming investments! Rolling over a 401K to a Traditional IRA can be as easy as a few clicks on your selected IRA broker's website or a simple call.
So do I save on taxes in my paycheck when I make a contribution?
Technically, no. I say contributions are "pre-taxed" in quotes, because they are not taxed slightly differently than pre-tax contributions to employer-sponsored retirement accounts, like a 401K or 403b.
When you contribute to an employer-sponsored retirement account, your employer is able to adjust and take out your payroll taxes accordingly based on your elected contribution amounts. Since a Traditional IRA is typically self-directed -- meaning you make any and all contributions yourself -- your employer is not able to adjust your payroll tax deductions for the contribution amount.
Instead, you get the benefit of a tax deduction when you file your taxes the following year. So for example, you contribute $500 a month to your 2020 Traditional IRA in order to max it out ($500 × 12 months = $6,000 maximum contribution). That $500 comes from your take home pay which has been taxed at your "expected" income rate based on your earned income (e.g. salary) and employer-sponsored deductions (e.g. 401K, healthcare, HSA, etc…). In April 2021, when you file your 2020 taxes, you can claim $6,000 in Traditional IRA contributions, which would bring your taxable income down by that $6,000.
That means if you are in the 12% income tax bracket, you potentially saved $720 in federal income taxes at tax filing time by maxing out your Traditional IRA.
Where can I open a Traditional IRA?
The great news is that almost all brokerage ﬁrms, investment/financial service companies, roboadvisors, and many banks offer a Traditional IRA. Some very popular firms are Vanguard, Fidelity, Charles Schwab, and Betterment.
The rules around Traditional IRAs are the same across all firms, so some of the things to look for are:
Investment fund options
Expense Ratios and Fees
Ease of use
Note: If you open an IRA with one firm and start making contributions for a given year, then rollover the funds mid-year to another firm's IRA, you will be responsible for keeping track of how much you contributed to each IRA to ensure you do not exceed the annual contribution limit. The new IRA firm will not know how much you have already contributed for the contribution year (January 1st to April 15th following year). Rolled over contributions (e.g. Traditional 401K to Traditional IRA or Traditional IRA @ Brokerage #1 to Traditional IRA @ Brokerage #2) do not count towards your annual contributions.
Pro Tip: If you change brokerage firms in the middle of the year, be sure to login to both accounts after December 31st and download your 1099s from both firms.
So there you have it. Everything you need to know about the basics of a Traditional IRA. There are so many great options you can do with a Traditional IRA to poise yourself for a successful retirement, early or otherwise.
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