Retirement for Beginners: The Traditional IRA Explained

In the world of retirement, there a TON of accounts to consider. Knowing which retirement account is right for you is important because there are rules and benefits that might be different depending on which account you choose.

I wanted to talk about the Traditional IRA because it's the most common and well-known retirement account. It's up to you to learn about these accounts and make the decision on which one is right for you. If you decide to hire someone or talk to a Financial Advisor, being a part and knowledgeable about the conversation can help . It also allows you to make the most informed decision possible.  So let's get to it.

What Is a Traditional IRA?

Traditional IRA: A Traditional IRA is a retirement savings account. You pay taxes as ordinary income on your money only when you start taking withdrawals during retirement. This account is also known as a tax-deferred retirement account which means that any income or capital gains tax that is generated during the life of the account are paid at the time of withdrawal rather in the period in which they were incurred. This is very important to know because deferring taxes allows the income and gains generated in the account to compound, allowing your account to grow much faster than a taxable account.

Deductible VS Nondeductible

Traditional IRAs come in two different varieties. Knowing which one to use depends mostly on your income level and whether or not you have access to an employer-sponsored or work-related retirement account like a 401K.

Deductible Traditional IRA: This is definitely the best option of the two. Deductible means you can deduct your contributions on your tax return allowing you to reduce your tax bill. You basically get a refund on the taxes you paid earlier in the year when you made your contributions.

Nondeductible Traditional IRA: You can not deduct contributions on your taxes with this option.

There are a lot of different factors that determine which one of these options you can use. Your income, filing status, access to a work-related retirement account, and whether you get social security benefits are all things that play a role on which one you can use.

Who Can Contribute to a Traditional IRA?

If you or your spouse have taxable income (you get a W2) and you are under the age of 70 1/2 you can contribute to a Traditional IRA. Super easy. The harder part is determining whether or not you can contribute to a Deductible Traditional IRA. Here are some general rules:

• If you have no retirement plan at work and you are under 70 1/2 years old you can contribute (up to the annual contributions limits) and deduct the full amount of the contribution on your taxes.
• If you do have a work-related retirement account, you can still deduct your contributions as long as your AGI (Adjusted Gross Income) is below a certain amount. For 2016, if your AGI is below $61,000 for an individual and below $98,000 for married couple filing jointly you can deduct your contributions on your taxes. These amounts are subject to change. Make sure you always check the limits and regulations on IRS.gov to make sure you have the most updated information.
• If you do have a work-related retirement account, there is a phase-out limit for making deductible contributions. If you are married and are filing jointly and have an AGI above $118,000 or are single and have an AGI of $71,000 or more than the deduction of your contributions is completely phased out.

It is so important that you understand that these limits change. Once again, I highly suggest that you check out IRS.gov to make sure you have the most accurate and updated information.

How to Open & Invest in a Traditional IRA

If you are wanting to open and invest in a Traditional IRA, you can open one through a brokerage firm (Fidelity, Scottrade, Vanguard, Charles Schwab etc.) online or through a local brokerage firm or bank.

• Related: What You Need to Know Before You Invest in Mutual Funds

How Much Can You Invest in a Traditional IRA?

The contribution limits are subject to change. I highly recommend looking at the IRS.gov website every year before making a contribution. For 2016, you can make a maximum contribution of $5,500 if you are under 50 years old. There is a $1,000 catch-up contribution if you are over 50 years old for a total contribution of $6,500.

When Can You Take Money Out?

You can withdrawal or take a distribution from your Traditional IRA at any time. It's so important that you know the rules regarding distributions from a Traditional IRA.

• If you are OVER the age of 59.5: Your full distribution will be taxed as ordinary income for the year in which you take the distribution.
• If you are UNDER the age of 59.5: Your full distribution will still be taxed as ordinary income for the year you take the distribution BUT you will also be taxed a 10% penalty.

This is one of the most important things I want you to remember with a Traditional IRA. If you decide to take a distribution before you are 59.5, not only will you be paying regular income taxes on the full distribution amount but you will also pay a 10% penalty for taking an early distribution. I would never recommend you take distributions from your Traditional IRA before 59.5.

For example: If you take a $2,000 distribution when you are 40 years old and you are in the 15% tax bracket, you will pay about $300 (2,000 * .15) for ordinary income taxes BUT you will also pay $200 for the 10% early distribution penalty. That's a total percentage of 25% and a total of $500 for income taxes and penalty. (These are just estimates and are for example purposes only. Please consult with a tax advisor before making a decision to take a distribution from your Traditional IRA)

There are exceptions to the 10% penalty rule for certain circumstances. Some of these exceptions include first time home buyer, education, disability and education costs. You can find the full list of exceptions on the IRS.gov website.

Required Minimum Distribution

As discussed above, you can start taking qualified distributions from your Traditional IRA at age 59.5 penalty free. However, the Traditional IRA has a feature called a Required Minimum distribution, also known as an RMD. In the year that you turn 70.5 and every year after, you are required to take an RMD. The amount you have to take is complicated and depends on your life expectancy according to the tables published by the IRS and how much you have saved over the life of the account.

• Related: How to Save for Retirement When You're Self-Employed

Benefits of a Traditional IRA

Traditional IRAs usually benefit people who expect to be in a lower income tax bracket when they retire. Since you are able to deduct your contributions now, you are able to lower your tax bill. When you get to that point during retirement and start taking distributions from your Traditional IRA, you will be in a lower tax bracket, thus spending less money on taxes.

Example: If you are interested to see what a Traditional IRA can do for your retirement check out this calculator. I used this calculator to figure out that if I am 30 years old, starting with a Traditional IRA with a $0 balance and I contribute $5,500 every year (max amount) until I am 50 years old and then $6,500 every year after until I retire at age 66, I will have a Traditional IRA with a balance of $1,144,137. This assumes an expected rate return of 8% and a retirement tax bracket of 15%. Of course, the expected rate of return will vary depending on what you invest in within in your Traditional IRA, but it's a great tool to show you how compounding works and the benefits of investing.

Get a free analysis of your Roth IRA

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Additional Resources

This is an introduction to Traditional IRAs and does not include everything. If you are really want to dig deeper into Traditional IRAs here are some really amazing articles for you to check out.

What is a Traditional IRA – Restrictions and Benefits by Mark Riddix via Money Crashers

Best Brokers for IRA Retirement Accounts in 2016 by Rob Berger via Dough Roller

How to Set up an IRA by Shannah Compton via Everyday Finance

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