Investment Glossary – Traditional IRA
The word “traditional” has always bothered me when discussing the Traditional IRA. Traditions are behaviors or beliefs that you repeat on a regular basis and usually pass down to the next generation. My mom’s Thanksgiving stuffing recipe is a tradition. Shooting off fireworks on the Fourth of July is a tradition. Contributing to a retirement savings account…well, it’s not. But, nomenclature aside, though I still believe the better name would be “Conventional IRA”, the Traditional IRA is a tax-deferred retirement savings vehicle that allows you to contribute what are usually pre-tax dollars in order to save for your retirement. Here’s the short version – you put money in the account, (usually) get a tax deduction, and you don’t have to pay any taxes on the gains until you pull the money out of the account.
In 2020, the maximum amount you can contribute to a Traditional IRA is $6,000 per year. If you are age 50 or over, you can also throw in an extra $1,000 as a “catch-up contribution”, meaning you can contribute up to $7,000 per year. Typically, you will get a tax deduction for the amount you put into a Traditional IRA, but there are phase-outs to this deduction if your income rises above certain levels. And to make things more complicated, the phase-out thresholds vary based on whether you are covered by a workplace retirement plan and if you contribute to that plan.
So let’s start first for people who do have access to a workplace retirement plan, such as a 401(k) or 403(b), and also contribute to it. For a single person in this situation, the deduction phase-out range starts at $65,000 in Modified Adjusted Gross Income (MAGI), and is completely phased out once your MAGI is above $75,000 in 2020. For married couples filing jointly, the phase-out begins at $104,000, and is completely phased out at $124,000. So if your income falls into one of these thresholds, you are likely to see the deductibility of your contribution partially reduced, and if you’re above the maximum, you will have the deductibility fully reduced. You can still make the contributions, you just can’t take a tax deduction on your return.
What happens if you don’t make contributions to an employer-based plan but your spouse does?
If you don’t make contributions to an employer-based plan but your spouse does make contributions, the phase-out has a completely different set of numbers for 2020. In this case, it starts at $196,000 in MAGI, and the phase-out is complete at $206,000 in MAGI. Is your head spinning yet? Well there’s one more case to consider.
If you don’t contribute to an employer-based retirement plan, and as long as your spouse doesn’t either, there aren’t any income limits on the deductibility of your IRA contribution. That’s pretty simple. No work-based option that you’re contributing to? You can always make a deductible Traditional IRA contribution.
Once money is into your IRA, whether you got a deduction or not, the money is generally not taxed until you withdraw the funds. This means you don’t pay taxes on dividends, interest, capital gains, or just about any other type of growth in a Traditional IRA. When you do withdraw the money, it is treated as ordinary income, taxed at the federal, state, and city levels just as if it were income that you earned at a job. If you did make non-deductible contributions at some point, you do need to track that basis throughout the life of your Traditional IRA, and likely consult with a tax professional, as your basis is typically not taxed upon withdrawal, though the earnings are still taxed as ordinary income.
One thing to keep in mind about Traditional IRAs is that there are penalties for early withdrawal. If you pull money out of a Traditional IRA prior to age 59.5, you are typically hit with an additional 10 percent tax penalty on the amount you withdrew. There are nine cases where you can get a waiver of this penalty, but check with a tax preparer to make sure you have proper documentation and that your situation clearly fits into one of these if you need to use your Traditional IRA in one of these scenarios.
Traditional IRAs also have what are called Required Minimum Distributions (RMDs) that the federal government requires you to take once you reach a certain age. That age was changed at the start of 2020. If you turned 70.5 in any year prior to 2020, you were required to begin RMDs at age 70.5. If you have not yet turned 70.5 as of the start of 2020, the age for your first RMD is 72 years old. RMDs occur each and every year, and the penalty for not taking an RMD is 50 percent of the amount you were supposed to take out. So if you have an RMD of $1,000 and you don’t take it, you owe a $500 penalty in addition to the regular taxes you have to pay on the withdrawal once you eventually take it as well.
IRAs are a simple and easy way for individuals and families to save for retirement. There is a ton of flexibility as far as available investment options are concerned, with everything from ultra-safe CDs to any stock you can buy available inside an IRA chassis. There are also a number of other investment options, including mutual funds, exchange-traded funds, annuities, and a whole list that is too long to put here. The key concept behind the Traditional IRA is that it gives you tax-deferred growth and a tax deduction up front in many cases. Also, remember that any money you placed into a Traditional IRA is taxed at ordinary income rates upon withdrawal, and these types of accounts provide a large number of available investment options. The flexibility and tax benefits make Traditional IRAs an attractive option to consider for retirement savings, provided you don’t need the money before the early-withdrawal penalty expires.