The Traditional IRA was the original individual retirement plan which came into existence when the Employee Retirement Income Security Act of 1974 was passed by Congress. The intent of these plans was to allow a worker, who was not covered by a pension or 401k plan, to accumulate tax advantaged savings for eventual retirement. In 1997, the Roth IRA came into existence which allowed workers even more flexibility in saving for retirement.
Other plans have come into existence for specialty purposes, but each of these is an offshoot of either the Traditional IRA or Roth IRA concepts. These special IRA’s are the Spousal IRA, Educational IRA, SEP IRA, Rollover IRA, and the Inherited IRA.
Here we will concentrate on the original Traditional IRA since it is still a very popular and rewarding means of saving for your retirement.
The purpose of a Traditional IRA is to allow you to make contributions to a saving account, or mutual fund or brokerage account, and take a current tax deduction for the amount of contribution. The advantage is similar to why you put money in your 401k.
Since you get a tax deduction, the IRS wants to ensure that you are using this plan for retirement saving, and not just as a place to stash tax deferred assets. So a number of rules and limitations are imposed.
There are only two rules which determine if you are eligible to open a Traditional IRA. The first rule is that you must be under age 70 ½ at the end of the year in which you make a contribution.
The second rule is that you receive some form of earned income. This income can be from salary, commissions, or any form of payment that you receive from performing work. Earned income does not include interest income, dividends or any other passive type of payment.
Once you have determined if you are eligible to open an IRA, you then need to look at the income limits to determine if you can actually make a tax deductible contribution. If you do not satisfy these limits, you can still make a contribution, but you can’t take a tax deduction for that amount.
You also have an issue if you are covered under another pension, profit sharing or 401k plan. If you are, then you must satisfy a different and lower set of income limits, as shown below.
Now that you have determined you are eligible to contribute, and meet the income limits, you can then look at how much you can contribute.
You can contribute a maximum of $5,000 per year to a Traditional IRA, regardless if you are taking a tax deductible. If you are over age 50, you can put in $6,000 per year. You cannot contribute more than your actual compensation. So, if you earn $2,500, this will be our maximum contribution allowed.
These limits also apply to both spouses together. Each spouse could open his or her own IRA, but the total of the contributions cannot exceed the above limits.
These limits will be increased to reflect inflation increases.
Traditional IRA Withdrawals
You can make withdrawals without penalty after your reach age 59 ½. But you will have to pay ordinary income tax on the amount withdrawn, including your own contributions. This is because you took a tax deduction for your contributions when they were deposited.
If you make a withdrawal before age 59 ½, the IRS imposes a 10% penalty on the amount you take out, unless you an exception applies. These exceptions are the taking of a withdrawal due to death, disability, and certain education expenses.
You are required to start taking minimum withdrawals once you reach age 70 ½. If you do not start minimum withdrawals by this age, the IRS will hit you with a 50% additional penalty on the amounts not withdrawn. This is one of the stiffest penalties found in the tax law, and is intended to stop taxpayers from extending their tax deferrals indefinitely.
Rollovers into a Traditional IRA
You can move assets from another retirement plan into a traditional IRA. You might want to do this if you lose your job and want to consolidate your assets. You will probably have more flexibility of investments than you did under the former retirement plan.
To do this you simply notify your employer and your current IRA provider that you want to move the funds. They will then perform a tax free direct rollover from one institution to the other. Make sure it is a “direct” rollover between the two institutions. You never want to have your employer send you a check so that you can deposit it in your IRA. There are time limitations, tax considerations and potential nightmare’s involved in doing this. Always have the money flow from one institution to the other without you being in the middle.
Under a Roth, you do not receive a tax deduction for contributions, but all withdrawals are totally tax free when you retire. This may be better suited to your particular financial situation. You should read material concerning the Roth IRA for more information on Roths.
You might also be able to contribute to a Roth even though you are over the limits for a Traditional IRA. Again, you should understand the advantages and disadvantages of each form of IRA before you make a contribution.
Traditional IRA’s need Consideration
Tax deductible contributions for your eventual retirement can really increase your savings and provide for a more comfortable retirement. Don’t simply procrastinate if you don’t understand them. Reading and asking questions will lead you in the right direction.