Updated: Sep 24, 2021
In the first part of this series we examined the ubiquitous 401k, the backbone of most individuals’ retirement plans. In this part we’ll examine the Traditional Individual Retirement Account, or IRA as it is more commonly known. IRA’s come in two flavors: the Traditional IRA and the Roth IRA. Each has identical contribution limits and with each you can begin taking penalty-free withdrawals at age 59.5. The biggest difference between the two is their tax treatment; Traditional IRA contributions are tax deductible and provide tax deferral until the money is withdrawn while Roth IRA contributions are still taxed as regular income. The key feature of Roth IRA’s is that qualified withdrawals are tax free whereas withdrawals from a Traditional IRA is taxed at regular income tax rates. Each type of account has advantages and disadvantages, which type is best for you depends on many factors.
The Traditional IRA is a fairly simple type of account. The contribution limit for 2021 is $6,000 for taxpayers under 50 and $7,000 for those over 50. One of the key features of a Traditional IRA is that contributions are generally tax deductible, so long as one’s income is below a certain level. I don’t want to get into the guidelines regarding deductibility in this article, they’re beyond the scope of this piece. For more information on how deductions work contact your tax professional or financial advisor. Withdrawals from a Traditional IRA can be made without penalty once the account owner reaches the age of 59.5. Withdrawals can be made prior to that point under certain circumstances such as the purchase of a first house, educational expenses, and for medical expenses. Withdrawals prior to age 59.5 that aren’t due to one of the abovementioned reasons are subject to a 10% penalty, on top of the taxes which will be assessed. Speaking of taxes, taxation of Traditional IRA’s is relatively simple. When withdrawals are made the money counts as ordinary income.
Traditional IRA’s have several advantages which make them attractive to investors saving for their retirements. If you’re currently in a high tax bracket, the tax deduction can be useful. They can also be advantageous if you’re in a high tax bracket currently and expect to be in a lower bracket during retirement. Deferring the payment of taxes allows you to take advantage of the lower tax rate. Traditional IRA’s also offer flexibility as to when taxes are paid. Withdrawals don’t have to begin until age 70.5 so it is possible to defer taxes up until that point.
Like with all things in life there are disadvantages to Traditional IRA’s as well. One of the largest is that all withdrawals are taxed as ordinary income. This means that it isn’t possible to take advantage of lower capital gains tax rates. Another disadvantage is that, unlike with Roth IRA’s, minimum distributions must be made every year beginning at age 72. Roth IRA’s have no required minimum distribution. A third disadvantage is that early withdrawals are penalized 10%. However there are exceptions to the early withdrawal penalty, as I mentioned earlier.
Traditional IRA’s are a great way to save for retirement. They make sense for a lot of people due to the fact that they offer many investment options along with preferential tax treatment. Traditional IRA’s can be self-directed through an online account such as Vanguard or they can be managed professionally. Like with all retirement accounts, the most important part is that you make your yearly contributions.