How does a traditional IRA work? What are the rules that apply to it? Is there anything interesting you should know about this type of IRA before you open one? Can you roll over the funds in your traditional IRA to another IRA? If you are reading this article, I am almost certain that it is because you are looking for answers to the questions such as the ones I have highlighted above. The good news is that I will present the information you need in the rest of this post, so all you have to do is read on to discover what you ought to do.
What is a traditional IRA?
A traditional IRA is essentially a tax-deferred retirement plan that one opens outside their employer’s retirement plan. This type of plan allows them to contribute their pre-tax dollars to the Individual Retirement Account (IRA) until the allowed time for withdrawal, during their retirement years, comes. Upon retirement, the traditional IRA owners’ withdrawals are usually taxed. In some cases, traditional IRA account owners usually receive tax deductions that are equal to their contributions. The extent of the tax deductions is, however, dependent on one’s income and tax filing status.
Upon depositing your money in a traditional IRA, you are allowed to invest in a tax-deferred manner, and all the money invested during your working career is allowed to grow without annual tax assessments. This alone makes traditional IRAs a suitable investment vehicle for those whose financial plans align with the benefits offered by this type of retirement plan. Those who are willing to commit to investing their money over a long-term horizon can turn to a traditional IRA in a bid to grow their wealth while taking advantage of the underlying tax advantages.
What are the rules that apply to traditional IRAs?
Age-related contribution rules
You can start contributing to your traditional IRA at any age, provided that you have managed to earn an income of at least the amount that you are required to contribute. There was a time when those aged past 70.5 years were not allowed to contribute to a traditional IRA.
The set contribution limits
For the tax-year lasting between 2021 and 2022, the IRS has set the IRA contribution limit to $6,000 for traditional IRAs as well as Roth IRAs. Depending on one’s income and tax filing status, they can receive a tax deduction of $6,000.
Those who are older than 50 years can contribute an extra $1000 ( in total they get to contribute $7000), for the tax year lasting between 2021 and 2022. The extra $1000 they contribute is referred to as a catch-up contribution.
One is allowed to start making withdrawals from their traditional IRA without any penalties at age 59.5 years. Those who attempt to make withdrawals before hitting this age without any qualifying reason end up paying income taxes on the withdrawals they make, as well as an early withdrawal penalty (usually 10% of the funds in their account).
In addition to that, you are required to take the Required Minimum Distributions (RMDs) as soon as you hit 72 years. RMDs are mandatory withdrawals that ensure that an account owner eventually begins paying income tax.
The amount of RMD is dependent on the account owner’s life expectancy, as calculated by the IRS actuaries. The RMDs are usually taxed as ordinary income, hence the need to analyze the impact of the RMDs on one’s financial plan.
Can you transfer the funds in a traditional IRA?
Yes. You are allowed to transfer the funds in your traditional IRA to a new brokerage platform or to even merge it with a different type of IRA. Before transferring the funds in your traditional IRA, it is necessary to establish whether the tax status of the IRA or retirement plan you are sending the money to matches that of your current traditional IRA.
You can, for instance, roll over the funds in your current traditional IRA, to a Gold IRA. Rolling over the funds in a traditional IRA to a Gold IRA comes with extra benefits, which you can learn about by reading the review of our recommended Gold IRA companies.
Is a 401(k) a traditional IRA?
No. a 401(k) is different from a traditional IRA, in that it is an employer retirement plan that employees receive as a workplace benefit. The two plans, however, happen to share several characteristics, but they are quite different and have different rules altogether.
Traditional IRAs are independent retirement accounts that one can open on their own, and are separate from their employers’ retirement plan. This means that the rules surrounding the traditional IRAs are different, and vary based on one’s personal circumstances.
The Advantages of a Traditional IRA
A traditional IRA has a couple of benefits, which include:
- There are no age limits for contribution
- One can benefit from the tax-deferred growth
- A good option for those who want to set up extra retirement savings vehicles, beyond what their employers are offering them as benefits.
- A varying number of investment options are allowed ( If you want more investment options, then you should consider opening a self-directed IRA instead).
- One can easily roll over the funds in their traditional IRA to other retirement plans.
The downsides of traditional IRAs
Common downsides associated with traditional IRAs include:
- You may end up paying more taxes upon retirement
- The tax benefits are limited despite one being eligible for the full deduction.
- RMDs usually increase the plan owner’s taxable income during their retirement years
- They have complicated rules
- The recent elimination of stretch IRA means that the beneficiary of a traditional IRA must liquidate it within 10 years.
- It may not be the best retirement plan to receive as a beneficiary since it comes with due tax liabilities
If you are not very enthusiastic about opening a traditional IRA, based on the above downsides, then I would recommend that you try out a self-directed IRA instead.
That will be all for this article in which we have addressed the question “how does a traditional IRA work?” and other questions. I hope that you found the article helpful and that you will now make a more informed decision as to whether you will open a traditional IRA, or whether you will turn to another retirement plan. Let me know if you have any questions with regards to today’s topic- drop them in the comments section so that I can respond to them ASAP.
I wish you well,
Eric, Investor and Team Member at Gold Retired!