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Traditional IRAs: Everything you need to know

At a glance:

  • What is a traditional IRA?

  • Tax advantages of a traditional IRA

  • Deductible IRA contributions and taxes

  • When IRA distributions are allowed

  • Ways IRA distributions can be taken

  • When IRA distributions are taxed

  • Summary of traditional IRAs

If you want to pay less income tax and save for your retirement, you may be interested in a traditional individual retirement account (IRA). Besides adding to your retirement nest egg, the contributions you make may be tax-deductible. The rules can be complex, though.

Traditional IRAs offer you a way to save for retirement and may allow you to deduct all or part of your contributions from your current taxable income. The amount you may deduct from your current taxable income depends upon your adjusted gross income (AGI) and whether you are covered by an employer-sponsored retirement plan.

However, when you withdraw funds from your traditional IRA, your distributions are taxable, so you save taxes only when you make contributions but pay them when you make withdrawals. This could be a benefit if you are in a higher tax bracket while making contributions but in a lower tax bracket when withdrawing.

Traditional IRAs have significant tax advantages for those who qualify and should be considered as part of your retirement planning.

What is a traditional IRA?

The traditional individual retirement account (IRA) is a popular retirement plan for many investors. Besides helping build your retirement nest egg, the contributions you make may be tax-deductible.

The traditional vs. the Roth

In order to identify the traditional IRA, it may help if we distinguish it from the Roth IRA. The differences lie in deductibility and taxability. For the sake of clarity, remember that every IRA has two components: the contributions you make to it, and the potential earnings that grow in it.

The traditional IRA has these characteristics

  • Contributions you make may be tax-deductible.

  • If your contributions are deductible, you will be taxed on them when you make withdrawals (your contributions must be taxed at some point).

  • Any dividends or capital gains that accumulate on your contributions will not be taxed until you make withdrawals and are taxed as part of your gross income in the year distributed.

The Roth IRA has these characteristics

  • Contributions you make are never tax-deductible.

  • You will not be taxed on your contributions when you withdraw them if you follow all the rules.

  • Any dividends or capital gains achieved from your contributions will not be taxed at all if you begin making withdrawals after age 59½ and you have waited at least five years to do so.

Contribution limits

The largest contribution allowable to either plan for 2020 is the smaller of $6,000 or 100% of earned income from employment. Unmarried individuals must have earned income in order to contribute to IRAs.

In many situations, spouses of income-earners who have little or no earned income of their own may rely on their spouse's earned income to make an IRA contribution. One must not exceed the maximum contribution amount for all traditional and Roth IRA accounts combined.

Millennials aren't contributing as much to their retirement. (Graphic: David Foster/Cashay)
Millennials aren't contributing as much to their retirement. (Graphic: David Foster/Cashay)

The law also allows taxpayers age 50 and above to make an extra, "catch-up" contribution of $1,000. So, in 2020, taxpayers have a $7,000 annual IRA contribution limit in the year that they turn 50 (and every year until the year before they turn 70½).

If you are currently in a high tax bracket but foresee being in a lower one after you retire, you can benefit greatly from a traditional IRA, because your withdrawals will be taxed at the rate that applies when you make the withdrawal.

Outside of specific exceptions provided by the IRS, distributions prior to age 59½ are subject to an additional 10% tax penalty.

Tax advantages of a traditional IRA

In many cases, the contributions you make to a traditional IRA can be deducted from your taxable income. This is one of the popular attractions of these retirement accounts.

How it works

When you deduct IRA contributions, you subtract them from your taxable income for the year you made them. For instance, let us say you earned $33,000 this year. Let us also say that you contributed $4,000 to your traditional IRA. You can deduct that amount, leaving you with $29,000 on which to be taxed. There is, however, an income limit after which you cannot deduct the full amount.

If you find that you do not qualify for deductibility, you can still contribute to a traditional IRA. In this case, yours would be a non-deductible IRA.

Spousal IRAs are made for married couples

If you are married and you or your spouse is not working or has earned only a minimal income, either of you may set up what is called a spousal IRA. As long as one spouse has earned income at least equal to the total amount you contribute for both spouses, each of you may set up an IRA.

For 2020, a maximum of $6,000 may be contributed to each account per year. The law also allows each taxpayer age 50 and older to make an additional "catch-up" contribution of $1,000 for each of those years.

Earnings are tax deferred

In a traditional IRA, any dividends and capital appreciation that accrue to your account are tax-deferred. That means that the government cannot tax them until you withdraw them. For instance, if your IRA earns $100,000 over the years, that $100,000 will not be taxed until you withdraw it.

Retirement savings, tax-deductible contributions, and tax-deferred earnings are three reasons for the enduring popularity of the traditional IRA among many investors.

Deductible IRA contributions and taxes

Can you deduct your contributions to an individual retirement account (IRA) from your income for tax purposes? The answer depends on your income level and filing status, among other factors.

If you are single

Your contributions are fully deductible if you are single and not covered by another employer plan. If you are married and neither you nor your spouse is covered by another employer plan, contributions are also fully deductible.

Contributions to an IRA made after 1986 are not fully deductible if the individual participates in an employer-sponsored retirement plan. Individuals who are covered by such a plan must use their adjusted gross income (AGI) from their tax forms to determine how much may be deducted.

If you are married and in an employer plan

For 2020, if you are married, filing jointly, and both you and your spouse are covered by an employer plan, IRA deductibility begins to decline at MAGI over $104,000. At $124,000, it drops to zero.

If you are married, filing jointly, and you are covered by an employer plan, but your spouse is not, your IRA deductibility also begins to decline at MAGI over $104,000.

If you are married, filing jointly, and your spouse is covered by an employer plan, but you are not, your IRA deductibility for 2020 begins to decline at MAGI over $196,000. At $206,000, it drops to zero.

If you are single and in an employer plan

For 2020, the phase-out starts at $65,000 if you are a single taxpayer. The maximum allowable deduction drops as your adjusted gross income rises above these limits, called phase-out points. Once your MAGI reaches $10,000 over the phase-out point, your deduction is zero. For 2020, this point is $75,000.

IRS Publication 590a provides worksheets to help you with your calculations.

Knowing your eligibility for taking the IRA deduction can help you decide whether to invest in the traditional IRA, or whether some alternative, such as the Roth IRA, is the best plan for you.

IRA deduction for married filers when one spouse has another retirement plan

When only one spouse is covered by an employer-sponsored retirement plan, both spouses may deduct all or part of his or her IRA contributions subject to limits determined by their joint adjusted gross income (AGI) from their federal income tax return.

Phase-out of the covered spouse's deductible contribution begins once the joint AGI reaches $104,000 for 2020. Deductibility declines as AGI rises, reaching zero at $124,000.

The non-covered spouse has full deductibility up to $196,000 of joint AGI for 2020. This also declines as AGI rises. At $206,000, deductibility drops to zero.

Depending upon the family adjusted gross income, each spouse may deduct all or part of his/her traditional IRA contribution. The amount they may deduct is calculated separately for the spouse with the employer-sponsored retirement plan and the spouse with no employer-sponsored plan.

IRS Publication 590a provides worksheets to help you with your calculations.

When IRA distributions are allowed

Normal distributions from your IRA are allowed after you reach age 59½. At this age, you may begin making voluntary withdrawals. Once you have reached the age of 70½, however, you are required by law to take distributions. There are IRS formulas that will help you determine how much you must withdraw after age 70½.

The 10% penalty tax

If you take a premature withdrawal before 59½, you will be charged a 10% penalty tax on top of the regular income taxes you'll owe on the withdrawn amount. However, you can withdraw without penalty under any of these exceptions:

Exceptions

  • You become disabled.

  • You die, in which case the money in the IRA is paid to your beneficiary.

  • You incur certain medical expenses. They must exceed 10% of your adjusted gross income and cannot be covered by insurance.

  • You pay health insurance premiums while unemployed. There are certain conditions you must meet to qualify for this exception.

  • You need the money to pay certain college expenses.

  • Your withdrawals are made as part of a series of equal annual withdrawals based upon your life expectancy.

  • Buying a home for the first time if the home is to be a principal residence. The limit is $10,000 over your life.

  • The distribution is due to an IRS levy of the qualified plan.

  • The distribution is a qualified reservist distribution.

Although the rules can be complicated, knowing your withdrawal options will make withdrawing your IRA money a much easier and more cost-effective way to retire.

Ways IRA distributions can be taken

You've faithfully been contributing to your individual retirement account (IRA) for years. Now, how do you get your money out? There are three ways you can take distributions from an IRA.

You can take distributions in the form of interest or dividends

You can have them distributed to you monthly, quarterly, semi-annually, or yearly. If you do not want all of your interest and dividends sent to you, you may elect to receive a portion of each and have the rest automatically reinvested into the IRA.

You can elect an option in which you periodically sell assets from your plan

This works for brokerage and mutual fund IRAs. The plan will sell a certain amount of securities every month, quarter, etc. and distribute the proceeds to you.

You can also elect a systematic withdrawal plan made of equal payments

In this plan, called the annuity method, the IRA distributes an equal amount of money to you at least once a year. If it is in a broker or mutual fund plan, the plan may have to sell securities to do this. Your withdrawals may be based upon your current life expectancy, especially if you are older than 70½. There are government life expectancy tables available to help you figure your life expectancy. You may also choose to receive payments based on the joint life expectancy of the IRA owner and beneficiary.

If you are older than 70½

There is a minimum distribution requirement for those older than 70½. This requirement distributes the amount equal to the balance in your account divided by your current life expectancy. This amount is adjusted each year for your attained age.

How you elect to receive your IRA distributions will probably be determined by how your IRA fits in to the rest of your retirement income, especially when it comes to taxes.

When IRA distributions are taxed

You probably anticipate that the IRS will want a portion of your individual retirement account (IRA). But how much of your IRA distribution is subject to taxes, and when must they be paid?

What an IRA is made of

It is important to remember that your IRA consists of both the contributions you have made over the years and the earnings on your contributions. The earnings include reinvested interest and dividends that have accrued over the years on the contributions you have made, as well as the appreciation of your investment. When you make a withdrawal from your IRA, it may include portions of your original contributions.

Distributions from deductible IRAs are fully taxable, while distributions from non-deductible IRAs are partially taxable. That part of a distribution attributable to non-deductible contributions (after-tax dollars) is not taxed; taxes were already paid.

What is taxable

Here is the breakdown of what is taxable upon withdrawal in an IRA:

  • All earnings are taxable.

  • All tax-deductible contributions are taxable.

When you take distributions, you must separate nondeductible contributions from earnings, and nondeductible contributions from tax-deductible contributions. The IRS has formulas that can separate these amounts.

If you take distributions before a certain age

Of course, distributions that are taken before age 59½ will be hit with a 10 percent penalty unless they meet the special exceptions in the tax code.

The rules we've discussed here apply to traditional IRAs. Remember that each type of individual retirement account has its own special rules. Be sure to study each type carefully to learn the details of its contribution and withdrawal rules and its tax privileges.

Summary of traditional IRAs

If you are currently in a high tax bracket but foresee being in a lower one after you retire, you may benefit from a traditional IRA, because your withdrawals will be taxed at your lower rate in retirement. Many retirees fall to a lower tax bracket after they stop working, and this can save them on taxes.

However, not all contributions to a traditional IRA are deductible. Deductibility depends on whether you or your spouse is covered by an employer-sponsored retirement plan. If you or your spouse is covered by another retirement plan, this limits your contributions depending upon your adjusted gross income as calculated on your income tax return.

Even if your deductible contributions are limited by your adjusted gross income, you may still make a non-deductible contribution up to the maximum contribution allowed by law each year.

Contributions made to an IRA must stay in the IRA until you reach 59½ and must start to be withdrawn by the time you are 70½. Failing to follow these rules might result in taxes and penalties unless you meet the requirements of certain exceptions.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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