Many of us don’t think of saving for retirement often and, if you’re young, it may not even be on your radar at all. However, the earlier you start, the more potential you have for your money to grow, and you can acquire some pretty solid financial habits along the way.
There are many different ways to save and invest to pursue your retirement goals, and they all have their own advantages. Let’s explore what a traditional IRA is and the benefits that could come with it.
Traditional IRA explained
A traditional IRA is an individual retirement account that allows individuals to direct their pre-tax earnings toward investments that can grow tax deferred. The only time you will pay taxes on your investment earnings in retirement is if you withdraw or distribute the money in your account. Traditional IRAs can be a great retirement solution, so read on to learn how and why a traditional IRA may be a good fit for you.
How does a traditional IRA work?
If you have earned income, you are eligible to contribute to a traditional IRA. Your contributions grow tax-deferred and there are no income limitations. You can also purchase and sell a broad range of assets with a traditional IRA including stock, bonds, mutual funds and ETFs. If you choose to make withdrawals from your IRA before the retirement age of 59 ½, you may incur a 10% tax penalty from the IRS. However, when you process a distribution, you’ll owe regular income tax (taxed at your income tax rate) on some or all of your contributions and earnings.
Is a traditional 401k the same as a traditional IRA?
While both accounts work as investment vehicles for retirement and offer tax advantages, the main difference between these two accounts is that an employer opens a 401k on behalf of their employee and with a traditional IRA, you’re able to open, fund and invest on your own.
A traditional IRA allows you to make contributions that are tax-deductible depending on your tax filing status and your income. The money in your account grows on a tax-deferred basis and when it’s withdrawn, it’s typically taxed. Traditional IRA contributions are deductible, but if you or your partner are covered by a retirement plan at work, the amount you can deduct may be reduced or eliminated.
Traditional IRA contribution limits & guidelines for 2022
Traditional IRAs have contribution limits. For 2022 an individual may contribute up to $6,000 to an IRA. If you’re age 50 or older you may contribute $7,000. However, you must have enough earned income to cover your contribution. So, if your earned income for the year is less than the contribution limit, you can only contribute up to what you earned. For example, if you earned $4,000, you could contribute a maximum of $4,000.
While you do have some freedom with a traditional IRA, you also have a new set of responsibilities that come with lots of rules. If those rules are broken, you may face a penalty.
Why would I want a traditional IRA?
A traditional IRA may be a powerful tool to enhance your savings by avoiding taxes while you’re building your nest egg. Opening a traditional IRA is a great solution and the world of investments is wide open to you.
You want to reduce your tax burdens right away
Contributions to a traditional IRA may be tax-deductible in the year that you make them. That means you may be able to deduct the amount you deposit into your IRA from your taxable income, so you may pay less income tax for the year.
Keep in mind that those tax deductions are subject to government-set income limits. In addition, any growth on this type of IRA is tax-deferred until you withdraw funds.
Paying less in taxes now lets you save more
An added bonus of reducing the amount you have to pay in taxes now is that it may allow you to contribute more to your IRA (within federal limits) for retirement later. Just remember you do have to pay taxes when you pull the money out.
To see what this would look like, spend some time plugging your own numbers into an IRA calculator. This should help you get a feel for how different scenarios might play out for your individual situation.
You expect to be in a lower tax bracket when you retire
Unfortunately, you don’t know what the future holds, so estimating your tax bracket at retirement may take some guesswork. But if you think you’ll be in a lower tax bracket when you retire you might be better off with a traditional IRA.
Why? Because if you deduct your contributions now, your current tax bill ends up being lower. When you start taking distributions in retirement at a lower tax rate, you’ll pay less in taxes then, too.
You’re not covered by a retirement plan at work
If your employer doesn’t offer a retirement plan, a traditional IRA may be a good way for you to put away pre-tax dollars. Keep in mind that depending on your marital status and whether your spouse is covered by a retirement plan at work, you may be subject to income-based deduction limits.
You’re not eligible for a ROTH IRA
Another reason you may want to check out traditional IRAs: you make too much money to contribute to a Roth IRA. You can’t contribute to a Roth IRA if your income exceeds government-set limits, so check the IRS website to see if your income is eligible for a Roth IRA. If not, a traditional IRA may be a great opportunity.
If you are eligible for both, compare features to see which one fits your retirement goals. It’s also a good idea to visit the Internal Revenue Service website for specific, up-to-date information. If you aren’t sure a traditional IRA is right for you, there are a few other types of IRAs available. However, these also come with their own rules and tax benefits.
Ally Bank offers deposit IRA products along with the safety and security of FDIC insurance, up to the maximum allowed by law.
Ally Invest offers invest IRA products tailored to customers who prefer to manage their own trading as well as those who prefer a hands-off solution. Just remember, investing involves risk, including loss of principal. Ally Invest products are not FDIC-insured, not bank guaranteed, and may lose value.
What are the pros and cons of a traditional IRA?
There are many advantages that come with a traditional IRA, and it has grown to be a staple in many households. And while it has a wealth of advantages, it doesn’t come without its drawbacks. Here are few of them.
Pros of a traditional IRA
- You have access to invest in a wide selection of diverse assets, including bonds, ETFs, stocks, financial assets and other alternative investments
- There are no income limits when you contribute to a traditional IRA
- Deferred taxes allow for increased compound growth of investments
- Savings may be used for certain purposes without incurring any early distribution penalties
Cons of a traditional IRA
- Annual contributions are limited to only $6,000 for individuals ($7,000, if age 50 or older)
- Early withdrawal penalties will apply for distributions that are taken prior to age 59 ½
- If covered by a workplace retirement plan, tax deductibility in reduced/eliminated at higher incomes
- The year that you turn 70 ½, whether you need it or not, you must start withdrawing the minimum amount of money and you will still have to pay taxes on it
When deciding on whether to invest in a traditional IRA or not, you may want to weigh in on what your retirement goals are. While there are quite a few IRAs to choose from, it’s a smart idea to compare them to determine which will work best for your situation. There are a number of great reasons to open a traditional IRA.