A traditional IRA (individual retirement account) is an account that is used to save pre-tax dollars for use in retirement. An IRA can be opened at a variety of places such as a brokerage, mutual fund company, or even at your local bank. The money in the account can generally be invested in stocks, bonds, mutual funds, or CDs, subject to the availability of products within your account.
The Pre-Tax Advantage
The primary benefit of a traditional IRA is that in most cases, the contributions are made on a pre-tax basis. This means that when you deposit money into the IRA, you can deduct that amount from your taxable income. This results in paying less income tax for the year. For 2007, the maximum contribution to a traditional IRA is $4,000, and $5,000 if you are age 50 or older.
In addition to receiving the tax deduction up front, the money in the account grows tax-deferred. Any interest or capital gains from the investments are not taxed when the gains are realized. Instead, they are deferred until money is withdrawn from the IRA, at which point the money is taxed as ordinary income.
Anyone with earned income is eligible to open a traditional IRA, but there are some restrictions as to who can deduct the contributions. There are income limits that are used to determine how much of the contributions are deductible, if any at all.
If you are currently covered by a retirement plan at work in 2007, deductibility for traditional IRA contributions are phased out if your modified adjusted gross income is:
- More than $83,000 but less than $103,000 if married and filing a joint return
- More than $52,000 but less than $62,000 for a single individual or head of household
- Less than $10,000 for a married individual filing a separate return
If you live with your spouse or file a joint return, and your spouse is covered by a retirement plan at work but you are not, the deduction is phased out if your modified adjusted gross income is more than $156,000 but less than $166,000.
One of the potential disadvantages of a traditional IRA is the forced distribution that must begin at age 70 ½. Even if you don’t need the money, if you do not take at least the required minimum distribution (RMD) each year, you are subject to stiff penalties. In addition, withdrawals made prior to turning age 59 ½ are subject to an early withdrawal penalty in addition to taxes owed.
Is a Traditional IRA Right for You?
If your employer doesn’t offer a retirement plan, then a traditional IRA is generally your best option for saving pre-tax money for retirement. Keep in mind that depending on whether or not you’re married and if your spouse is covered by a retirement plan at work, you may be subject to income limitations.
For many people, once they reach retirement, they find themselves in a lower tax bracket than when they were employed. This means you receive a greater tax break on the contributions during your working years, and later in life when you are not working and withdraw this money, it is taxed at a lower rate. Unfortunately, it is impossible to predict what will happen to tax rates in the future, which is why it is important to have multiple sources of retirement savings.