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What's a Traditional IRA and How Does it Work?

Jun 24, 2021 4 min read Teri Cettina

Key takeaways

  • A traditional IRA can give you a current tax break when you save for retirement.
  • It can be a good place to roll over a 401(k) if you change jobs.
  • You can play “catch up” with extra contributions if you’re at least age 50.

 

 

What is a traditional IRA?

If you’re investing for your life after work, you’ve likely heard about individual retirement accounts (IRAs). But what’s a traditional IRA exactly and how do you decide if it’s a good option for you?

A traditional IRA is a type of investment account that lets you save money, tax deferred, for retirement. (Technically the IRS calls it an individual retirement arrangement.) You can open the account through a brokerage, mutual fund company or other financial provider.

 

How does a traditional IRA work?

When you contribute to a traditional IRA, you may be able to deduct those funds from your current federal and state income taxes. The trade-off: You’ll owe income tax on your money (and any earnings) later, when you withdraw—typically during retirement.

This is the big advantage of traditional IRAs: During retirement, you may be in a lower tax bracket than when you were working (and saving). As a result, you could end up paying less in taxes on your investments.

 

What are the benefits of traditional IRAs?

There are several reasons to consider opening a traditional IRA.

First, if you don’t have a retirement plan you can contribute to at work like a 401(k) or 403(b), a traditional IRA enables you to create your own.

Next, if you have a workplace plan but don’t like your investment options (or simply want to supplement them), an IRA can offer a broader range of choices, depending on the provider. (Just pay special attention to IRS income limits in that case.) And if you end up switching jobs, a traditional IRA can be a good place to roll over your workplace account. After all, you might not be allowed to keep your retirement money with your former employer—or you might not want to. A traditional IRA lets you take it with you and keep it tax deferred. Last but not least are those tax breaks: A traditional IRA may allow you to pay less in current taxes. For example, a 35-year-old who earns $150,000 a year can invest up to $6,000 in a traditional IRA in 2021. Assuming they don’t have access to a workplace plan, that contribution reduces their taxable income to $144,000, resulting in a lower federal tax bill when they file for the year.

 

Traditional IRA vs. Roth IRA

There are two basic types of IRAs: traditional IRAs and Roth IRAs, which came into law later. The key difference is tax treatment: Unlike a traditional IRA, you fund a Roth with after-tax dollars, and withdrawals are tax free as long as you meet certain criteria.

Depending on your income and tax situation, you can invest in either or both of these accounts. Learn more about traditional vs. Roth IRAs to determine which might work best for you.

 

Does a traditional IRA earn interest?

An IRA is not an investment itself—it’s a special kind of container that holds your interest-gaining investments.

In general, you can include almost any type of investment in a traditional IRA—from bonds to mutual funds and exchange-traded funds (ETFs). When it comes to taking investment risk (to seek greater rewards), you can design your IRA to be as conservative or aggressive as you like.

 

Traditional IRA rules and contribution limits

Traditional IRAs have a few limitations and trade-offs to consider. Your financial professional can help you determine how the following rules will impact you:

  • Income limits:

    Anyone with earned income can deposit money into a traditional IRA. However, you‘ll only receive a tax deduction Opens in new window if you earn less than the annual IRS limit.
  • Contribution:

    For 2020 and 2021, you can put up to $6,000 in a traditional IRA. If you‘ll be age 50 or older by Dec. 31, you can add another $1,000 Opens in new window in “catch-up” contributions to that amount. (Contributions for the 2021 tax year must be made by April 15, 2022 (or the later applicable due date of your federal income tax return, without extension)).
  • Mandatory withdrawals:

    The IRS requires you to start taking money out of your traditional IRA—and paying taxes on it—every year, starting at age 72. These withdrawals are called required minimum distributions (RMDs). RMDs kick in after age 72 (unless you reached 70½ in 2019).

 

Can my spouse and I both open traditional IRAs?

Yes. The contribution guidelines and tax rules Opens in new window will vary according to your incomes, whether you have workplace retirement accounts and whether you file your income taxes separately or jointly.

An IRA can be a valuable part of almost any investor‘s retirement strategy. If you happen to fall within the income limit, a traditional IRA can give you a nice upfront tax break, too.

 

What you can do next

Compare the benefits of traditional and Roth IRAs. A financial professional can help you decide which one (or both) is right for you. And remember that if you opt for a traditional IRA, you have until next year’s Tax Day to snag a deduction on contributions for this year.

Please consult your tax and legal advisors regarding your particular circumstances.

Footnotes

Teri Cettina is a personal finance writer based in Portland, Ore.

 

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