What Is a Traditional IRA?

Traditional IRA

A type of individual retirement account that lets your earnings grow tax-deferred. You pay taxes on your investment gains only when you make withdrawals in retirement.

A traditional individual retirement account (IRA) allows individuals to direct pre-tax income toward investments that can grow tax-deferred. The IRS assesses no capital gains or dividend income taxes until the beneficiary makes a withdrawal. Individual taxpayers can contribute 100% of any earned compensation up to a specified maximum dollar amount.

Income thresholds may also apply. Contributions to a traditional IRA may be tax-deductible depending on the taxpayer's income, tax-filing status, and other factors. Retirement savers may open a traditional IRA through their broker (including online brokers or robo-advisors) or financial advisor.

Key takeaways

  • Traditional IRAs (individual retirement accounts) allow individuals to contribute pre-tax dollars to a retirement account where investments grow tax-deferred until withdrawal during retirement.
  • Upon retirement, withdrawals are taxed at the IRA owner's current income tax rate. Capital gains or taxes on dividends are not assessed.
  • Contribution limits exist ($6,000 for 2021 and 2022 for those under age 50, $7,000 for those 50 and older), and required minimum distributions (RMDs) must begin at age 72.
  • Unqualified withdrawals from a traditional IRA prior to the age of 59.5 years old are subject to income tax in addition to a 10% penalty.
  • Unlike Roth IRA contributions, traditional IRA contributions are deductible from your current taxable income.
How Traditional IRAs Work (Source: investopedia.com)

How Traditional IRAs Work

Traditional IRAs let individuals contribute pre-tax dollars to a retirement investment account, which can grow tax-deferred until retirement withdrawals occur (at age 59½ or later).Custodians, including commercial banks and retail brokers, hold traditional IRAs and place the invested funds into different investment vehicles according to the account holder’s instruction and based on the offerings available.

In most cases, contributions to traditional IRAs are tax-deductible. If someone contributes $6,000 to their IRA, for example, they can claim that amount as a deduction on their income tax return and the Internal Revenue Service (IRS) will not apply income tax to those earnings. However, when that individual withdraws money from the account during retirement, earnings are taxed at their ordinary income tax rate.

The IRS restricts the amount that one may add to a traditional IRA each year, depending on age. The contribution limit for the 2021 and 2022 tax year is $6,000 for savers under 50 years of age. For people aged 50 and above, higher annual contribution limits apply via a catch-up contribution provision, allowing for an additional $1,000 (or a total of $7,000) per year.

Under the SECURE Act, passed at the end of 2019, age restrictions on contributions to a traditional IRA were lifted. As long as the account holder has earned income to qualify, they are eligible to contribute to a traditional IRA regardless of age.

The maximum amount an individual under age 50 can contribute to a traditional IRA for the tax year 2022 (unchanged from 2021).

Traditional IRA Distributions

A Roth IRA must be established with an institution that has received IRS approval to offer IRAs. These include banks, brokerage companies, federally insured credit unions, and savings and loan associations. Generally, individuals open IRAs with brokers.

A Roth IRA can be established anytime. However, contributions for a tax year must be made by the IRA owner’s tax-filing deadline. This is normally April 15 of the following year. However, the deadline for the 2021 tax year is April 18, 2022.

Two basic documents must be provided to the IRA owner when an IRA is established:

  • The IRA disclosure statement
  • The IRA adoption agreement and plan document

These provide an explanation of the rules and regulations under which the Roth IRA must operate, and they establish an agreement between the IRA owner and the IRA custodian/trustee.

Not all financial institutions are created equal. Some IRA providers have an expansive list of investment options, while others are more restrictive. Almost every institution has a different fee structure for your Roth IRA, which can have a significant impact on your investment returns.

Your risk tolerance and investment preferences will play a role in choosing a Roth IRA provider. If you plan on being an active investor and making lots of trades, you want to find a provider that has lower trading costs. Certain providers even charge you an account inactivity fee if you leave your investments alone for too long. Some providers have more diverse stock or ETF offerings than others; it all depends on what type of investments you want in your account.

Pay attention to the specific account requirements as well. Some providers have higher minimum account balances than others. If you plan on banking with the same institution, see if your Roth IRA comes with additional banking products. If you’re looking at opening a Roth IRA at a bank or brokerage where you already have an account, see whether existing customers receive any IRA fee discounts.

Most IRA providers offer only regular IRAs (traditional or Roth). For an SDIRA, you’ll need a qualified IRA custodian that specializes in that type of account, which allows assets beyond the typical stocks, bonds, ETFs, and mutual funds.

Traditional IRAs vs. Other IRA Types

Other variations of the IRA include the Roth IRA, SIMPLE IRA, and SEP-IRA. The last two are employer-generated, but individuals can set up a Roth IRA if they meet the income limitations. These individual accounts can be created through a broker. You can check out some of the best options with Investopedia's list of the best brokers for IRAs.

What Can You Contribute to a Roth IRA?

The IRS dictates not only how much money you can deposit in a Roth IRA but also the type of money that you can deposit. Basically, you can only contribute earned income to a Roth IRA.

For individuals working for an employer, compensation that is eligible to fund a Roth IRA includes wages, salaries, commissions, bonuses, and other amounts paid to the individual for the services that they perform. It’s generally any amount shown in Box 1 of the individual’s Form W-2.

For a self-employed individual or a partner or member of a pass-through business, compensation is the individual’s net earnings from their business, less any deduction allowed for contributions made to retirement plans on the individual’s behalf and further reduced by 50% of the individual’s self-employment taxes.

Money related to divorce — alimony, child support, or in a settlement — also can be contributed if it is related to taxable alimony received from a divorce settlement executed on or prior to Dec. 31, 2018.

So, what sort of funds aren’t eligible? The list includes:

  • Rental income or other profits from property maintenance
  • Interest income
  • Pension or annuity income
  • Stock dividends and capital gains
  • Passive income earned from a partnership in which you do not provide substantial services

You can never contribute more to your IRA than your earned income in that tax year. And, as previously mentioned, you receive no tax deduction for the contribution — although you may be able to take a Saver’s Tax Credit of 10%, 20%, or 50% of the deposit, depending on your income and life situation.

Opening a Traditional IRA

You can open a traditional IRA as long as you received taxable compensation during the year you want to contribute or your spouse earned taxable compensation and you will file a joint return. If both you and your spouse have compensation, both parties can open their own traditional IRA.

A variety of organizations, financial institutions, or brokerage firms can assist in setting up a personal traditional IRA. The account is subject to IRS code requirements, and the custodian of your account (often the brokerage firm you choose such as Fidelity or Vanguard) will manage the account requirements on your behalf.

Contributions into a traditional IRA can be made immediately through your account holder in the form of cash, check, or money order. Physical property is not an allowable contribution type. When setting up an account, there is no minimum balance or starting investment required.

What Is the Difference Between a TraditionalIRA and Roth IRA?

The primary difference between a Traditional and Roth IRA is the tax treatment of each account. Traditional IRA contributions are deductible from taxable income when the contributions are made; however, earnings are taxable. Alternatively, Roth contributions are not deductible but can grow tax-free.

In addition, there are differences on the mechanisms of each IRA. Roth IRA contributions can be withdraw for no penalty, while Traditional IRAs can not. In addition, some Roth earnings may be able to be withdrawn for no penalties for specific uses (i.e. first time homebuying down payment).

What Are the Rules for a Traditional IRA?

There are several rules for a traditional IRA. The maximum contribution amount depends on your age, and the IRS requires individuals to begin taking money out of their traditional IRA at age 72. The traditional IRA is subject to income taxes and a 10% penalty if unqualified withdrawals occur before 59.5 years old. Last, your annual contribution into a traditional IRA can not exceed what you earned in the contribution year.

What Are the Different Types of IRAs?

The two most common types of IRAs are the traditional IRA and Roth IRA. Less popular types of IRAs include SEP IRAs (often best for self-employed or small business owners), SIMPLE IRA (often best for small companies that still have numerous employees), or self-directed IRAs (often used by experienced investors seeking specific alternative asset investments).

Does a Traditional IRA Grow Tax-Free?

No, a traditional IRA does not grow tax-free. Contributions into a traditional IRA receive favorable tax treatment and is often deducted from an employee's taxable income. When it is time to withdraw earnings, any growth on the investment is taxable. In the meantime, earnings are tax-deferred. This is opposite treatment of Roth IRAs where initial investments can not be deducted from income, but its growth can be withdrawn tax-free at retirement.

The Bottom Line

One of the more common vehicles used for saving for retirement is the traditional IRA. A traditional IRA allows for savers to contribute money into a tax-deferred vehicle using post-tax (deductible) contributions. Although this investment vehicle can't be accessed until retirement without taxes and penalties, taxes on the growth of your investment is deferred until retirement.