What Is a Traditional IRA & How Does It Work?

For many people, a traditional IRA can be an effective way to invest more money toward retirement while lowering their tax bill. However, this type of retirement account does come with limitations, including how much you’re allowed to contribute each year and when you can take withdrawals.

How does a traditional IRA work?

A traditional individual retirement account, or IRA, lets you contribute money towards retirement with pre-tax income. That means you don’t have to pay taxes on eligible contributions in the year you make them. So if you contribute, say, $1000 in 2021, you can reduce your taxable income by that same amount when you file your federal tax returns for that year. Experts consider this one of the primary traditional IRA benefits. Additionally, your invested funds aren’t subject to taxes until you take distributions from your account.

A traditional IRA is a type of account that you can open through a brokerage firm or robo-advisor. You may choose your own investment strategy based on your risk tolerance and timeline for retirement.

Traditional IRA withdrawals

Since this type of account is designed to help you prepare for retirement, you must wait until you turn 59 ½ before you can begin taking distributions from your traditional IRA. If you withdraw funds before that age, you’ll have to pay a 10% penalty in addition to state and federal income taxes.

There are some exceptions if you use the early withdrawn funds for certain purposes, such as:

• Buying or building a first home (lifetime limit of $10,000)
• Expenses related to giving birth or adopting a child (limit of $5,000)
• Paying for higher education expenses, if you qualify
• Paying for medical expenses not covered by insurance, if those expenses amount to more than 7.5% of your income
• You become disabled
• The IRS levies funds to repay tax debt
  

Traditional IRAs also come with required minimum distributions (RMD). Once you reach age 72, you are required to withdraw funds each year (and consequently, pay taxes on them). You may withdraw more than the RMD.

Who can open a Traditional IRA? Traditional IRA income limits

Unlike a Roth IRA, there are no income limits for contributing to a traditional IRA. However, the size of your eligible income tax deduction may be impacted if you’re also covered by an employer-sponsored retirement plan.

The 2021 phase-out ranges are as follows for anyone with access to a workplace 401k plan:

• Single taxpayers: $66,000 to $76,000
• Married filing jointly: $105,000 to $125,000
• Not covered by workplace plan, but married to someone who is: $198,000 to $208,000

Maximum traditional IRA contribution limits

The IRS announces new maximum contribution limits each year for traditional IRAs. Individuals who are 50 years or older may contribute more as a catch-up contribution, since they’re closer to retirement age.

Here are the 2021 traditional IRA contribution limits:

• $6,000 (through 49 years old)
• $7,000 (50 years or older)
  

You may still contribute more money to your IRA than those limits, but you won’t receive any tax benefits.

Who can open a Traditional IRA? Traditional IRA income limits

Unlike a Roth IRA, there are no income limits for contributing to a traditional IRA. However, the size of your eligible income tax deduction may be impacted if you’re also covered by an employer-sponsored retirement plan.

The 2021 phase-out ranges are as follows for anyone with access to a workplace 401k plan:

• Single taxpayers: $66,000 to $76,000
• Married filing jointly: $105,000 to $125,000
• Not covered by workplace plan, but married to someone who is: $198,000 to $208,000

Maximum traditional IRA contribution limits

The IRS announces new maximum contribution limits each year for traditional IRAs. Individuals who are 50 years or older may contribute more as a catch-up contribution, since they’re closer to retirement age.

Here are the 2021 traditional IRA contribution limits:

• $6,000 (through 49 years old)
• $7,000 (50 years or older)
  

You may still contribute more money to your IRA than those limits, but you won’t receive any tax benefits.

Roth IRA vs. Traditional IRA

In addition to a traditional IRA, a Roth IRA is another type of retirement savings account that comes with tax advantages. Like a traditional IRA, a Roth IRA comes with the same maximum contribution limits each year. You’ll also incur the same 10% penalty if you take ineligible withdrawals before you reach 59 ½ years old. But there are a few important differences between the two types of accounts:

1. The tax advantage works differently.

Instead of deducting the amount you contribute from your taxable income with traditional IRAs, with a Roth IRA you withdraw your funds completely tax-free in retirement. In other words, if your investments grow over the years so that you accumulate more money than you contribute, you don’t have to pay federal income tax on any of those earnings.

2. Income limits.

While there are no income limits associated with a traditional IRA (unless you also have access to a workplace 401(k) plan), there are income limits you must meet in order to make the maximum contribution to a Roth IRA:

• Single taxpayers: Less than $125,000 modified adjusted gross income
• Married filing jointly: Less than $198,000 modified adjusted gross income
  

3. Phase out limits.

There are phaseout limits for Roth IRAs as well, allowing you to contribute a reduced amount if you are within those thresholds:

• Single taxpayers: $125,000 to $140,000
• Married filing jointly: $198,000 to $208,000

Traditional IRA vs 401(k)

A traditional 401(k) is a retirement plan offered through an employer. (Note that there is a 401(k) option for self-employed people, known as a solo 401(k).)

A traditional IRA and a 401(k) share several common features.

• Contributions up to the annual limit are tax-free like a traditional IRA.
• You don’t pay any income tax on the money in your 401(k) until you start taking withdrawals during retirement.
• You incur a 10% penalty if you withdraw funds before you’re 59 ½ years old.
• Required minimum distributions begin at age 72.
  

Here are some of the key differences between a 401(k) compared to a traditional IRA:

• Employers may choose to match employee contributions to a 401(k). Since IRAs are not tied to an employer, there’s no potential match.
• The maximum annual contribution to a 401(k) is much higher. The maximum is $19,500 if you’re under 50 years old.
• You can make annual catch-up contributions up to $6,500 in a 401(k) at 50 years or older.
• There are no income limits in order to get a tax deduction on your 401(k) contributions.

When should you open a traditional IRA?

Experts say a traditional IRA is best suited for individuals who either don’t have access to a 401(k) or other employer plan, or who do have access to a 401(k) but whose income is under the limits to still qualify for the IRA tax deduction. That gives you access to the tax deduction, as well as more flexibility in your investment choices.

Traditional IRA pros and cons

Pros:

• No income limits on taking a tax deduction, unless you’re eligible for an employer-sponsored plan
• Growth is tax-deferred, so you don’t pay any taxes until you take withdrawals
• Several scenarios allow you to avoid early withdrawal penalty, including purchasing your first home or paying for college
• Catch-up contribution lets you save more as you near retirement age
• Flexibility in how you can invest your contributions
  

Cons:

• Most early withdrawals make you pay a 10% penalty plus income tax
• You must take requirement minimum distributions when you reach 72 years old
• You may not be eligible for the full tax deduction if you also contribute to a 401(k) or other employer-sponsored plan

The bottom line

A traditional IRA may lower your tax bill now while offering a long-term investment vehicle as part of your retirement strategy.