Traditional IRAs Let You Save Pretax Money for Retirement

Quick Summary:

  • IRAs allow you to save for retirement and get a deduction on your taxes.
  • With a traditional IRA, you get a tax break when you make your contribution and then have to pay taxes when you withdraw that money in retirement
  • You can only contribute $5,500 per year to an IRA ($6,500 if you are over 50) and there are limitations on eligibility.

What is a Traditional IRA?

An IRA is a tool that can help you save money for retirement. There are all sorts of IRAs, but the most common is a “Traditional” IRA. A Traditional IRA allows you to contribute up to a certain amount each year and deduct your contributions from your income taxes. The money grows over time and you pay taxes in the year you withdraw that money. We explain the traditional IRA in more detail below:

  1. Why open a Traditional IRA?
  2. What are the tax benefits of a Traditional IRA?
  3. Who is eligible?
  4. What are the contribution limits?
  5. What are the rules on deducting contributions?
  6. How do I invest my IRA?
  7. What happens if I withdraw the money early?
  8. When do I have to take the money out of an IRA?
  9. What are the fees on an IRA?

Why Open an IRA?

An IRA helps you minimize your taxes when saving for retirement.

A Roth IRA uses post-tax money and allows you to later withdraw the money and earnings tax free. A traditional IRA, on the other hand, allows you to deduct the amount you contribute (up to certain limits) in the tax year you contribute. You have to pay taxes on that money when you withdraw, but the money gets to grow tax-free until retirement.

Your individual financial situation may influence whether a Roth IRA or a Traditional IRA makes more sense, but in general, Traditional IRAs are best when you are in your prime money-making years and can make good use of tax deductions. Roth IRAs are best when you think your tax rates will go up in the future.

What are the tax benefits of a Traditional IRA?

The beauty of a Traditional IRA is that your money can grow faster than it would in a regular investment account because an IRA receives special tax benefits you don’t get from a regular account.

Traditional IRAs are especially appealing to employees who want to save for retirement but don’t have retirement plans at work. However, many people have both a 401(k) and an IRA. Typically, they contribute to their IRAs after they have contributed enough money into their 401(k)s to get their employer match.

Here’s an illustration of how you might benefit from the tax savings on a Traditional IRA.

Let’s say you contributed $5,500 to a Traditional IRA every year starting at age 30 and ending at age 60. Assuming a six percent rate of return, you’d have accumulated around $460,000 by the time you reached age 60. If you opted for a savings account instead, contributing $5,500 annually for 30 years, you might earn one percent in interest and accumulate $193,373 by the end of those 30 years. But remember that because you can’t contribute pre-tax money to a savings account, you’d actually have to earn $6,875 (assuming a 25 percent tax rate) in order to contribute $5,500 each year.

Even considering the taxes you’ll pay as you gradually withdraw funds from your Traditional IRA (likely at a lower tax rate once you retire), the tax advantages of an IRA make it more efficient than other savings vehicles.

Who is eligible?

Anyone under the age of 70 ½ with earned income (money from tips, salary, wages or self-employment; alimony, child support, interest and dividends do not count as earned income) or a spouse with earned income can contribute to a Traditional IRA.

If you have an employer-sponsored retirement plan such an a 401(k) or a 403(b), you can still put additional money into an IRA, but it may not be tax deferred (see our calculator for more). Or if your employer doesn’t provide any retirement benefits, you can save in a Traditional or Roth IRA. Non-working spouses can save for retirement using a spousal IRA, which can be a Roth or Traditional IRA. Once you reach age 70 ½, you’re no longer eligible for a traditional IRA, even if you’re still working.

What are the contribution limits?

For 2016 and 2017, you can contribute up to $5,500 (or it up to $6,500 if you’re age 50 or over) to a Traditional and/or Roth IRA. You can contribute to both types of IRAs for a given tax year, but your total contributions are subject to one combined contribution limit ($5,500 or $6,500 depending on your age).

If you contribute more than $5,500 (or if you’re over age 50, $6,500) or in an amount that exceeds your earned income to your IRA, then you’ve made an excess contribution. You can withdraw your excess contribution to avoid tax implications. Otherwise, excess contributions are taxed at six percent per year as long as the excess amounts remain in the IRA. The tax can’t be more than six percent of the combined value of all your IRAs as of the end of the tax year.

Funds rolled over from other retirement accounts, such as a 401(k) from a previous job, do not count toward your contribution limit.

Some other kinds of IRAs, including Simple IRAs and SEP-IRAs, have higher contribution limits. However, they are available generally only to small business owners or those with self-employment income. Small business owners with a SEP IRA can also contribute to a Traditional IRA if they choose.

What are the rules on deducting contributions?

If you’re covered by an employer-sponsored retirement plan and you’re also saving in a Traditional IRA, your ability to deduct contributions may be limited based on your income. For tax year 2017, if you file as single or head of household and are covered by a workplace retirement account, the IRS allows you to deduct your full IRA contribution if your modified adjusted gross income is $62,000 or less.

To check if you qualify, just enter your details into our IRA calculator

How can I invest my IRA?

Typically, you open an IRA account with a bank or brokerage company. A brokerage will generally have a customer service department that will help guide you through opening an IRA account and putting money in it. Then you can invest funds invested in your IRA virtually any way you like including cash, CDs, stocks, bonds, mutual funds, exchange traded funds (ETFs) and other vehicles.

As you’re picking your investments, look for low fees and investment choices you can understand. Or you can consult a financial advisor who can help you choose the investments for your retirement portfolio.

Most retirement accounts like Fidelity have a “target date fund” or “lifecycle fund” option where the investment mix automatically adjusts over time. You would pick the fund for the year that’s closest to when you want to retire (for instance, 2050 or 2035). Early on, the fund would invest aggressively because you can handle that level of risk when you are decades away from retirement. Then the investment choices gradually get more conservative as you near retirement. For example, Fidelity offers at least 33 different “Freedom” funds that have very low costs and various target dates.

You can usually open an IRA at a large brokerage company like E*Trade for free and with no annual fee. If you choose to trade, you would pay a fee for each trade. Some brokerages that charge an annual fee will waive it if you set up automatic deposits from your bank account. Many brokerages enforce a minimum deposit (typically $500 or $1,000) to open an IRA, but a few have no minimum deposit.

What happens if I withdraw the money early?

You can start withdrawing money from your IRA at age 59 ½. If you decide to withdraw money from your traditional IRA before then, the money is subject to regular income tax (at whatever your normal tax rate is), plus a 10 percent penalty, because the government wants to discourage early withdrawals. However, the IRS allows certain exceptions to the 10 percent rule, such as qualified first-time home buyer distributions or distributions made on account of a disability.

Minimum Distributions Are Required

Once you reach age 70 ½, you must take what the government calls “required minimum distributions” from your Traditional IRA. In other words, you need to start withdrawing a percent of the account each year. The calculation can be confusing (and you are welcome to withdraw more than the minimum if you choose), so many people consult a tax advisor or financial advisor. The IRS website also has worksheets and other tools to help you calculate your required minimum distribution.

Pay Attention to Fees

Rather than opening an IRA at the first brokerage you find, look for a no-fee IRA. A free or no-fee IRA means the brokerage isn’t charging you simply to hold or manage your money. That said, the underlying investments still carry fees. Online brokerages like Fidelity, E*TRADE, Merrill Lynch and Schwab let you choose from thousands of mutual funds, stocks, bonds, ETFs and other options. Compare the expense ratios of the funds before you buy and consider the commission you pay on each trade as you buy and sell investments within your IRA.

The Bottom Line

An IRA can you save for retirement. If you save the current maximum of $5,500 annually for the next 30 years, you will end up with more than $430,000, assuming a fairly conservative rate of return at six percent. But if you wait until later into your working years, you won’t get the same benefits of compound interest and you’ll miss out on the tax deduction.

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