How a traditional IRA works

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In the simplest terms, a traditional IRA is a pre-tax investment account.

You make contributions from your income before taxes are taken out, and the money grows tax-free until you withdraw it in retirement. There are limits on how much you can contribute each year.

IRA contribution limits
Contribution Year Under age 50 Age 50 and above
2018 $5,500 $6,000
2019 $6,000 $7,000

Depending on your income level, you may be able to get a tax write-off for your IRA contributions. But you can take a serious tax hit if you pull your money out of an IRA too soon.

When the right time comes to make withdrawals, the money you stashed away is taxed as income. How much you pay in taxes depends on your income tax bracket in retirement.

Since you're likely to find yourself in a much, much lower tax bracket in retirement than during your working years, putting money into a traditional IRA can be a great way to save on taxes.

The tax-deferral aspect combined with the years of compound interest equals more money for your retirement savings. It's a win-win.

Benefits of a traditional IRA

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Don't discount compound interest.

Anyone is eligible

First and foremost, any money put away for retirement is fundamentally a good thing. One enormous positive of the traditional IRA is that any working individual is eligible to set up an account and begin making contributions.

You could be building up your retirement savings before you even graduate high school.

A nice tax write-off

You IRA contributions may be tax deductible, up to the annual contribution limits. In 2019, you can contribute up to $6,000 of your earned income if you're under 50, or as much as $7,000 if you're 50 or older.

Better still, the IRA write-off is called an "above-the-line deduction," which means you can take it even if you don't itemize deductions.

The write-off cuts your taxable income — which lowers your tax bill.

Money for your first home

You can withdraw $10,000 of your IRA investments toward the cost of your first home. You’ll face taxes on the withdrawal, but won’t be subjected to the 10% early withdrawal penalty (which we'll touch on later).

Money for college

Similarly, you can use your IRA contributions to pay for college expenses. Again, you’ll face taxes on the withdrawal, but won’t have to pay the penalty.

Limits and requirements

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Don't deposit money if you aren't ready to sit on it for a long time.

No early withdrawals

The biggest caveat of making contributions to an individual retirement account is that you cannot touch your money too early, because withdrawals before age 59 ½ can be very costly.

The IRS will require you to pay a stiff 10% as a penalty. Also, early withdrawals from your IRA will be counted as income — meaning you could be bumped up to a higher tax bracket and owe more money at tax time.

Mandatory withdrawals post-retirement

But you can’t keep your money in your account indefinitely.

Once you turn 70 ½, you must start making withdrawals — called required minimum distributions — from your traditional IRA, or you’ll face a tax penalty of up to 50% of any amount you fail to take out as required.

You may not qualify for the tax deduction

Not everyone is eligible to deduct IRA contributions on their tax returns. Your income level can make things tricky.

If you're a single person and your adjusted gross income for tax purposes is more than $74,000 in 2019, you won’t be able to write off your IRA contributions.

If you're married and filing jointly, your combined adjusted gross income can't exceed $203,000.

Differences between a Roth IRA, a traditional IRA and a 401(k)

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The main difference between a Roth IRA and a traditional IRA is pre-tax versus post-tax contributions.

With a traditional IRA, you contribute pre-tax money. But with a Roth IRA, you pay taxes upfront on your contributions. When you withdraw the money in retirement, your withdrawals and earnings are usually tax-free.

A 401(k) is a retirement account that you open through your employer. A portion of the contributions you make to your 401(k) plan might be matched by your employer. (Yes, free money.)

So, a traditional IRA might be ideal for self-employed people, freelancers and small business owners — basically anyone who doesn't have a pension plan or 401(k).

Even if you're employed by a company offering a 401(k) program, you also may want to have a traditional IRA and/or a Roth IRA.

How can I get a traditional IRA?

Setting up a traditional IRA is as simple as going to the bank and showing a few pieces of identification.

Although there may be an initial deposit requirement, some banks will waive that if you show you have a steady income and are able to make regular contributions.

You also have the option of opening up your traditional IRA with a robo-advisor, such as Acorns. It's easy to open an account, and they do all the heavy lifting so you don't have to actively manage your IRA.

As a MoneyWise reader, get a $10 bonus on your first investment! Sign up now to take advantage of this special offer.

About the Author

Sarah Cunnane

Sarah Cunnane

Staff Writer

Sarah Cunnane is a staff writer at MoneyWise. She is a writing and marketing professional with an Honors Bachelor's degree in English and Creative Writing from the University of Toronto.

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