A traditional IRA can be an extremely powerful retirement planning tool. Like 401(k)s, they are tax-deferred savings accounts, so you pay taxes on your money only when you make withdrawals in retirement. In spite of their value, a large percentage of Americans are neglecting to consider traditional IRAs as viable saving options. So why aren’t more people taking advantage? Good question.
Following is an explanation of the purpose of an IRA, as well as some of the key rules and benefits to having one.
What is a traditional IRA?
First, let’s make sure we’re on the same page about what a traditional IRA is, and what it can accomplish. Historically speaking, this investment vehicle was first introduced in 1974. The traditional IRA was created to assist individuals not covered by their employers’ retirement plans, as well people switching jobs, with the ability to rollover retirement assets while retaining the tax-deferred status.
Interestingly, about 25% of U.S. households owned traditional IRAs in 2014, according to the Investment Company Institute (ICI). But only 12% of U.S. households contributed to any type of IRA in 2013, even though most households are eligible to make such contributions.
What rules must traditional IRA investors follow?
–Contributions are limited to $5,500 per year, or $6,500 if you’re age 50 or older.
–You must have earned income to contribute (alimony does qualify).
–Withdrawals from your IRA will be taxed as ordinary income.
–There are Required Minimum Distributions from your IRA starting at age 70½, with hefty penalties if you fail to take them (50% of what you should have taken out, plus income tax on the full amount).
–Withdrawals before age 59½ usually result in a 10% penalty, with the exception of the following: death; disability; medical expenses in excess of 10% AGI; health insurance premiums if unemployed for 12 consecutive weeks; qualifying higher education expenses for family members; qualifying first time home purchase ($10,000 lifetime limit); and substantially equal payments made over life expectance (see previous blog on IRS rule 72t).
What are the advantages of a traditional IRA?
–If you don’t have a retirement plan at work, you are eligible for a tax deduction for the amount you contribute each year.
–Money in the IRA grows tax-deferred.
The bottom line:
Now that you know the details, rules and advantages of a traditional IRA, consider whether it could be the right choice for your situation. Even if your employer doesn’t offer a 401(k) plan, a traditional IRA could be the perfect ticket to adequately save for the retirement of your dreams.