Coming out of the COVID-19 pandemic that has rocked our world, financial well being is a much higher priority for many people. We now have a greater understanding of the importance of saving for retirement. But how should you begin this investment in your future? There are many different types of individual retirement accounts (IRAs) that you can open. In this series of posts, we will be taking a look at each one to help you determine which is best for you. We will start with the traditional IRA.
Basic Types of IRAs
An IRA is a type of savings account, similar to a 401(k). However, where a 401(k) is only offered by an employer, an IRA can be opened by any person with earned income. These accounts come with tax advantages that can be used to benefit you long term.
There are a few different types of IRAs you can open. Each comes with its own benefits and things to be aware of. In this post, we will look specifically at traditional IRAs to help you determine if this is the best way to begin your savings journey.
You can open a traditional IRA through a broker, bank, or investment company. Once you have opened the account, you can fund it. For 2022, contributions to a traditional IRA are capped at $6,000 ($7,000 for individuals who are age 50 or older).
One thing to note is that these accounts are funded with pre-tax dollars, meaning your contributions will actually be tax deductible – providing you meet the income requirements necessary to qualify for this deduction. For individuals, your income must be less than $68,000 to receive the full deduction. For couples who are married filing jointly, income must be less than $109,000. Singles who have income between $68,000 and $78,000 can receive a partial deduction; couples who are married filing jointly and have income between $109,000 and $129,000 will receive the same. Anything above these ranges will result in no deduction.
The deadline for contributions to a traditional IRA is Tax Day of the year you’re making the contribution for. This year, the deadline will be April 18, 2023. So, even if you don’t have the funds for a full contribution by December of 2022, there is still plenty of time to contribute.
The gains in your traditional IRA won’t be taxed until you withdraw them. Typically, you can start withdrawing these funds at age 59 ½. These distributions will be taxed at your regular rate. There is no rule saying you must begin withdrawing funds at age 59 ½, but starting at age 72, you will be required to take a required minimum distribution (RMD).
Traditional IRA Positives
When it comes to a traditional IRA, there are quite a few positives to opening one of these accounts. For one, there are no income limits to open and contribute. So long as you have earned income, you can open a traditional IRA and contribute as much as you would like up to the $6,000 (or $7,000) limit.
The funds in your IRA will grow tax-deferred, meaning any gains you would pay taxes on for a typical brokerage account will be pushed further back. You are also able to claim the deduction for these contributions whether or not you itemize on your tax return, so long as you meet the income requirements mentioned above.
Finally, although you will typically pay a 10% early distribution penalty as well as taxes for withdrawing funds from the IRA prior to age 59 ½, there are a few exceptions made to this rule. For example, you can use money from a traditional IRA to pay for qualified college expenses without having to pay the early distribution penalty. Examples of qualified college expenses can include tuition, fees, books, supplies, and equipment required by the school.
Likewise, you can withdraw up to $10,000 from your traditional IRA for a purchase of your first home. Please keep in mind that in both of these instances, even though you will avoid the 10% early distribution penalty, you will still owe taxes on the distribution.
Things to Keep in Mind with a Traditional IRA
There are far more pros than cons when it comes to traditional IRAs, but it is still important to keep a few things in mind should you choose to open one of these accounts. First, the 10% early distribution penalty that was mentioned above. Unless your withdrawal is being used for one of a few specific exceptions, you will have to pay this penalty on any withdrawals made before age 59 ½.
Another thing to be aware of is the RMD requirement, which you will need to meet starting at age 72. This is because the IRS wants to start getting back some of that tax-deferred money, which has been growing from the time you opened the account. The RMD for each year must be taken by December 31st. Failure to take the RMD on time will result in a 50% penalty on the amount that was not withdrawn. For those with large IRA accounts, this could really hurt you.
Finally, you’ll want to pay attention to the income requirements listed above to determine if you will receive the benefit of the tax deduction for opening and funding this account.
Who Benefits Most from a Traditional IRA?
Those who meet the income requirements for the full tax deduction could benefit greatly from starting one of these accounts. If you think your income, and your tax rate, will be lower in retirement than they are currently, then this could also be a smart move for you since you won’t be taking withdrawals from this account until you retire.
So, How Do You Know If a Traditional IRA is Right for You?
As is the case with most aspects of retirement planning, there is no one perfect solution for everyone. Your individual circumstances will determine which accounts are best for your situation. If, after reading this article, you still are not sure if a traditional IRA is the right move for you, you may want to consider working with a fiduciary financial advisor.
Fiduciaries are legally required to work in your best interest. A fiduciary financial advisor will undertake a through examination of your goals and financial situation before making any savings recommendations. Feel free to contact our planners if you are interested in discussing retirement planning further.