What Is a Traditional IRA?

Updated on September 27, 2022

Couple seated at a desk, talking with an investment advisor — Photo: Image Source / Getty Images

Definition

A traditional individual retirement account (IRA) is an investment or savings account allowing you to save for retirement through annual contributions. Contributions and gains aren’t taxed until you take money out of your account.

Key Takeaways

A traditional IRA is an individual investment account allowing someone to defer taxes on investments and growth until retirement (age 59 ½ or older).
You must use earned income, such as pay from employment or self-employment, to invest in a traditional IRA.
When withdrawing funds from your traditional IRA, you pay the taxes on the amounts withdrawn. If you make a withdrawal before age 59 ½, a 10% penalty may apply.

How a Traditional IRA Works

A traditional individual retirement account (IRA) is an account you can set up to make retirement contributions if you meet specific requirements. The amounts contributed each year are considered “pretax,” meaning you don’t have to pay tax on the money in your IRA until you take it out. You can use your IRA funds for investments, or create an IRA savings or CD account.

A traditional IRA’s primary advantage is that it allows you to fully or partially deduct contributions from your taxable income for the year you contribute. This could lower your taxable income in your higher-earning years. The money you put into an IRA, as well as the money it earns, isn’t taxed until you take it out of the account. This is an advantage if your income (and therefore taxes) are lower in retirement.

You can contribute to a traditional IRA if you have taxable compensation, such as what you earn from working. Compensation can also include self-employment income, commissions, and taxable alimony and maintenance. It doesn’t include income earned from some other sources, including rental properties, deferred compensation, interest income, dividend income, or income from a pension or annuity.

You can contribute to a traditional IRA if you or your spouse participate in a retirement plan through work.

For 2022, your total contribution to all IRAs (traditional and Roth IRAs) is limited to $6,000 or your taxable compensation for the year, whichever is less. At age 50 or older, you can make “catch up” contributions of up to $7,000. If you are age 70 ½ or older, you may contribute any amount to your traditional IRA in a year, with no limit.

Note

Contributions over the IRS limit for the year may be subject to a 6% excise tax, unless you return the excess before the tax due date.

Contributions Are Deductible

Contributions to a traditional IRA are eligible for a tax deduction in the year they were made. The taxes are not actually forgiven, but are deferred—you’ll pay normal income tax on the money when you withdraw it.

Your annual deduction may be limited by your income and whether you’re in a retirement plan through work.

Withdrawals

You can withdraw assets from your traditional IRA account at age 59 ½. When you’re 72 ½, you must begin taking withdrawals each year from your traditional IRA of a specified amount, called a required minimum distribution (RMD), and include the withdrawal in your tax return for the year. If you take money from your account before you reach age 59½, you will pay any taxes and a 10% additional penalty.

Example of a Traditional IRA

Suppose you’re a single 30-year-old, and make $85,000 per year through your job. Your employer doesn’t offer a retirement plan, and you don’t have any retirement plan in place at all. You set up a traditional IRA with a financial institution in 2022.

You decide to put $6,000 of your earned income from your job into the IRA by the deadline, which is the April due date for your tax return in the year following the year you’re filing a return for. You can invest this amount in stocks, bonds, mutual funds, or other similar securities. Or you could put the $6,000 into an IRA savings account or CD at a bank.

Because your workplace doesn’t offer any sort of retirement plan, you can probably deduct the full amount from your taxes. Next year, you can make another contribution up to that year’s maximum.

If next year, you decide to take out, say, $1,000 of this amount, you will have to pay income tax on the withdrawal, based on your tax rate for the year, plus a 10% penalty.

Note

Your unique contribution and deduction amounts may be determined by your income, contributions to other traditional or Roth IRAs, marital status, and whether you’re covered by a retirement plan at work. Consult with a tax adviser to ensure you’re following the law.

Roth IRA vs. Traditional IRA

A Roth IRA is the other common type of IRA individuals tend to set up, but you contribute to it with after-tax dollars instead of pretax dollars. Here are the primary differences between a Roth IRA and a traditional IRA.

Traditional IRA	Roth IRA
You contribute with pretax dollars	You contribute with after-tax dollars
Can deduct contributions from your taxes if you qualify	Cannot deduct contributions from your taxes
Removing initial contributions can lead to taxes and a penalty	Can withdraw initial contributions at any time without taxes or a penalty
Features required minimum distributions	No required minimum distributions

How To Get a Traditional IRA

To set up a traditional IRA, find a financial institution (such as a brokerage firm) that the IRS approves to act as a trustee or custodian for an IRA account. Your contributions must be in the form of cash, check, or money order. However, every individual financial situation is different, and tax laws change frequently. Before you decide to set up a traditional IRA, talk to a licensed tax professional and a financial adviser to review your situation.

Frequently Asked Questions (FAQs)

What is a traditional IRA 401(k)?

A traditional IRA and a 401(k) are different retirement-saving vehicles. An employer sponsors a traditional 401(k), giving employees a choice of investment options for retirement. A traditional IRA is opened by and managed by an individual. You can have both a traditional 401(k) and a traditional IRA. You may not be able to deduct all of your IRA contributions if you also contribute to a 401(k) or another employer retirement plan.

What is a traditional IRA savings account?

Instead of investing in stocks or other securities, a traditional IRA savings account acts like a regular savings account. You can also get an IRA CD to save money for retirement. While a traditional IRA savings account isn’t as risky as the stock market, lower interest rates may not keep up with inflation, reducing the value of your retirement savings.

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Sources

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