The Traditional IRA concept is one of the best tax advantaged ways to save for retirement. Everyone should consider opening an IRA, but you may not be eligible or it just may not be right for your personal financial situation. So, before we consider who should open a Traditional IRA, we first need to review the requirements and restrictions that exist with these retirement plans.
Purpose of a Traditional IRA
The primary purpose of a Traditional IRA is to save for retirement and get the same tax deferred advantages that are allowed under other forms of qualified retirement programs where you work. You get a tax deduction for the amounts you put in. In exchange for this right, you are taxed on both your contributions plus your earnings when you withdraw later on.
The Eligibility Rules
There are two provisions which determine if you can open a Traditional IRA. One rule is that you must be under age 70 ½ when you make the contribution. The other rule is that your contribution must come from your earned income. So if you are retired and don’t work, you can’t make a contribution from the pension payments you receive.
If you are eligible to open an IRA, then you have to look at the rules to determine if you can actually make a contribution. If you are covered under a pension plan or 401k plan at work, you are covered under one set of rules. If you are not covered at work, you come under another set of rules. These rules apply to how much earned income you have each year. If you earn over the amounts in the tables below, you can contribute to a Traditional IRA, but you may not be able to take a tax deduction.
Once you determine you are eligible and can make a contribution, there are rules stating how much you can contribute.
You can contribute up to $5,000 per year to a Traditional IRA. If you are over age 50, you can put in an additional $1,000 per year. This assumes you have enough earned income to cover the amount of contribution.
These rules apply to you and your spouse together. So, if you open a Traditional IRA for yourself and contribute the maximum allowed, your spouse cannot make a similar contribution to his or her Traditional IRA account.
Rules for Withdrawals
You can take out money without penalty after age 59 ½. You will have to pay ordinary income tax on any withdrawals, including your own contributions.
If you take out money before age 59 ½, the IRS imposes a 10% penalty on the amount withdrawn, unless one you come under an exception. These exceptions are the taking of a withdrawal due to death, disability, and certain education expenses.
The IRS makes you start taking minimum amounts once you reach age 70 ½. If you do not start minimum withdrawals by this age, the IRS imposes a 50% additional penalty on your entire account. This is one of the harshest penalties imposed by the IRS, so take note.
Rollovers into a Traditional IRA
You can transfer money from your retirement plan or 401k into a Traditional IRA. If you lose your job, you might wish to make this transfer so that all your assets are in one place. (Read: How to Rollover a 401k into an IRA to find out more.)
The Roth IRA
The Roth IRA came into existence in 1997 and was intended to allow for additional savings. Under a Roth, you put your contributions but do not take a tax deduction for these amounts. However, when you withdraw your money in retirement, all withdrawals are totally tax free. There are a number of Roth IRA rules and you should read What is a Roth IRA and Its Benefits to understand the Roth in more detail.
Should You Open a Traditional IRA
Theoretically, the results of using a Traditional or Roth IRA are the same if you are in the same tax bracket all through your career. Under the Traditional you get a tax deduction now, but are taxed later. Under the Roth, you make after tax contributions now, but get the money tax free later.
However, people are rarely in the same tax bracket for their entire life. Most people will get salary raised during their career. Then, when they retire, their tax bracket may go down since their salary stops. Pension plans rarely give you the same payment each month as your salary.
From a financial viewpoint, if your tax bracket is expected to go down in retirement, you should put your money in a Traditional IRA. From a psychological viewpoint, you might want to consider splitting you contributions between a Roth and a Traditional IRA. Once you near retirement, the idea of having tax free withdrawals in ahead of you can be a very appealing concept.
Lastly, it could be that your income will go up in retirement. This occurs at times with municipal workers who earn an average salary all through their career, but have very healthy retirement plans under which they are covered. The pension plan combined with an IRA, and possibly working part-time after retirement could easily force your tax bracket to increase. In this case, you want to use a Roth IRA as your savings program since your withdrawals will be tax free.