Choosing where to invest your money is a crucial step in planning for the future, and differentiating between your various options can be overwhelming. We’ll keep it simple here as we look at the basics of the traditional IRA as well as some advantages and disadvantages.
What is a Traditional IRA?
“IRA” stands for Individual Retirement Account, and a traditional account allows you to direct your income towards investments, which can be tax-deferred until withdrawal. The money you place in a traditional IRA goes towards your retirement, and can be invested in various places, such as stocks, bonds, or real estate. Traditional IRAs are held and handled by a custodian.
Advantages and Disadvantages of the Traditional IRA
There are pros and cons specific to the traditional IRA. It’s important to know these.
Larger Sums to Invest
Since the money you will be investing is tax-deferred, the sum you will be able to invest will be larger than a post-tax savings plan. This can lead to larger interest accumulating for you over a period of time.
If you choose the Traditional IRA, know that you will have to withdraw a specific amount of your money before you reach age 71, otherwise you may be subject to confiscation automatically by the IRS. There is also a penalty if you withdraw funds too early. The IRS will assess and possibly penalize you a 10% penalty if you are under 59 ½. There are few exceptions to this such as death or disability.
Traditional IRA Rules
To qualify for the Traditional IRA you must be:
- Less than age 70
- Have enough income earned to make the contribution
For the traditional IRA, it is important to note that not everyone is eligible for tax deductions. It is highly dependent upon your income as well as your filing status. Here is some more information that you need to know about tax deduction limits:
- If you are married and filing jointly with your spouse or if you are a qualified widow the annual income limits allowed for tax deduction are $101,000 and $121,000.
- If you are married and filing jointly and you were not covered by an employee sponsored plan, but your spouse was, the income limits allowed for tax deduction are $189,000 – $199,000.
- If you are a single filer, the income limits allowed for tax deduction are $63,000 – $73,000.
- If you are married, but filing separately the annual income limits allowed for tax deduction are $0 – $10,000.
What are the contribution limits for the Traditional IRA?
For those below 50, the limit is $5,500 and for those above 50, the limit is $6,500.
Remember that by the time you reach age 70 ½ , if you have a traditional IRA, Required Minimum Distributions or RDMs, take effect. This means that you must withdraw at this point a minimum amount of money from your IRA because it is mandatory. If you fail to do so, the IRS will then confiscate half of your minimum amount automatically.
One last important thing to note about the rules: rollover may apply. This means that the funds from your traditional IRA may be rolled over, in some cases, to other retirement plans, with the exception of the Simple IRA and certain Roth IRAs.
What is the difference between a Traditional IRA and a Roth IRA?
Basically, with the traditional IRA, when you make you contributions, you are able to tax-defer when you first put money in. With the Roth IRA, it works the opposite way; you are able to avoid taxes upon withdrawal. There is also a big difference when it comes to when you have to withdraw. With the traditional IRA, there are specific restrictions and mandatory sums as well as a time frame. With the Roth IRA, there are no mandatory withdrawal rules.
Another important thing to note about withdrawals: with the Traditional IRA, there are penalties for withdrawal before age 59 ½, but with the Roth IRA, you can withdraw up to $10,000 of your earnings after the first 5 years you begin contributing to it with no penalty, even if you do this before age 59 ½. The contribution limits are the same for both options.
Can a Traditional IRA be converted to a Roth IRA?
Yes. In order to convert from a traditional IRA to a Roth IRA, you must first meet eligibility requirements. There are three different ways that your IRA can be converted.
- The Rollover
With this option, you can take funds that would be going to your traditional IRA, and instead roll them over into a Roth IRA, but it must take place within 60 days of the distribution.
- Between Two Trustees
With this option, the trustee you have in charge of your traditional IRA directs your funds to the trustee of your new Roth IRA account for you.
- Transfer With the Same Trustee
This option operates within the same bank or institution and is, in many ways, the simplest option. Your trustee for your traditional IRA sets up a new Roth IRA account and then proceeds to direct your funds there.
How do I know if the Traditional IRA is the best option for me?
First, look at your income in order to determine this. In tax year 2018, is it more than $120,000 if you are single or filing separately? Is it more than $189,000 if you are filing jointly? If so, the traditional IRA may be a great option. If it’s less, then you are eligible for the Roth IRA as well, and if this is the case, you should look at other factors before you make your final decision. This is where discussing it with a professional will come in handy the most, because you need to determine a projection of which tax bracket you will be in, and based on this, you can move forward with your decision.