Tax Treatment of Traditional IRA’s

The whole reason for opening a Traditional IRA instead of a simple savings account is the tax treatment of your contributions, earnings and withdrawals. This type of retirement plan was started in 1974 to give average workers a way of saving for retirement on a tax advantaged basis.

Contributions to a Traditional IRA

The contributions you make to a Traditional IRA are considered tax deductible. Technically, it is more accurate to say that your contributions reduce the amount of your salary subject to income taxes. So, if you contribute $5,000 to a Traditional IRA, and your W-2 shows you earned $60,000 for the year, the amount of earnings shown on form 1040 will be $55,000. Essentially, you save the tax on the amount of your contribution to a Traditional IRA.

Any time you are given a tax deduction, the IRS always imposes a number of rules. With Traditional IRA’s, the tax law was written to ensure that you are truly using the account to save for retirement. They don’t want high salaried workers using these retirement plans merely to put away large amounts just to avoid taxes.

Eligibility Rules for Traditional IRA’s

There are two rules which the IRS looks at to see if you are eligible to open a Traditional IRA:

  • You must have earned income. This can be salary, commissions or other form of payment that get from working for a living. Earned income is just that – Earned. So, if you are retired and living off a pension, you are not bringing in earned income. In this case, you cannot contribute to a Traditional IRA. Similarly, you do not have earned income if you are living off interest income, dividend income or other passive forms of payments.
  • The second rule is that you must be under age 70 ½ at the end of the year in which you make a contribution.

Limits on Earned Income

Just because you passed the two rules above, and can open a Traditional IRA does not mean that you can automatically contribute to the account. There are limits on the amount of income you earn which will determine how much you can contribute. If you earn too much, you cannot make a contribution.

Also, if you are covered under a pension or 401k plan at work, you are limited in the amount of contributions you can make. Again, the Traditional IRA is intended to allow average middle class citizens to save for retirement. So if you are a high wage earner or you have other taxed advantaged retirement plans, you will be limited in the amount you can put into a Traditional IRA.

How Much Can You Contribute

Once you determine that you are eligible to contribute, and are under the earned income limits, you can make a contribution.

The maximum amount of contribution to a Traditional IRA is $5,000 per year. If you are over age 50, you can put in an additional contribution of $1,000 per year. If you earn less than these amounts, you can only then put in the amount you earn.

Also, the contribution limits apply to both spouses combined. You can both open Traditional IRA accounts, but your combined contribution cannot go over these limits.

Tax Deferral on Earnings

While your money stays in the Traditional IRA, any earnings tax deferred. You will be taxed when you eventually take money out.

Withdrawal Rules

Withdrawals from your account can be made without penalty after age 59 ½. You will have to pay tax on the full withdrawal, including the amount of the contribution you put in. Since you took a tax deduction when you put the money in, you pay a tax when you take it out.

Withdrawals before age 59 ½ will be hit with a 10% penalty on the amount withdrawn, unless you come under one of the exception below:

    • Unreimbursed Medical Expenses – The penalty is not imposed if medical expenses are more than 7.5% of your adjusted gross income.
    • Medical Insurance – If you are unemployed and receive unemployment checks, you will not be hit with the penalty if you made the withdrawal to buy medical insurance for you and your family. This exception applies only if you did not take the withdrawal more than 60 days after being reemployed.
    • Disability – The penalty does not apply if you can’t work due to physical or mental problems, as certified by a physician.
    • IRA Beneficiary – If you die before age 59 1/2, your beneficiaries or estate can make a withdrawal without penalty.
    • Paying for Higher Education – If you made a withdrawal to pay for higher education, part (or all) of any distribution will not get hit with the 10% tax penalty.
    • Buying Your First Home – You can make an early withdrawal if you use the funds to buy or build your first home. This exception is limited to a withdrawal of $10,000, and must be withdrawn no more than 120 days after you buy a home.
    • Rollover into a Qualified Plan – If you rollover the withdrawal into a qualified pension or 401k plan within 60 days, the withdrawal is not subject to the 10% penalty.
    • Annuity Payments – If you take out money in substantially equal payments, the penalty will not apply. These equal payments must continue for at least 5 years or until age 59 ½.

The above exceptions only mean that you will not have to pay a 10% penalty on the amounts withdrawn. All withdrawals, no matter when you take them, are still taxed as ordinary income.

Minimum Withdrawals

You must start taking minimum withdrawals age 70 ½. If you do not start taking out minimum amounts by age 70 1/2, the IRS will impose a 50% additional penalty on the entire account. This is one of the harshest tax penalties found in the tax law. Simply stated, the IRS does not want you deferring tax forever.

Take Advantage of a Traditional IRA

All workers should consider opening an IRA, either a Traditional IRA or a Roth IRA (see Traditional IRA vs Roth IRA for a quick comparison). The tax advantages of these plans allow for more growth in your retirement savings than simply putting money in a savings account.

Don’t lose a tax deduction merely because you don’t want to read up on the subject or have to do the account opening paperwork. It will be worth it later on when you retire.

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