What is a traditional IRA and how does it work?
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Updated: January 02, 2025
A traditional Individual Retirement Account (IRA) is a tax-advantaged retirement savings account designed to help individuals save for retirement. Contributions to a traditional IRA are typically tax-deductible, meaning they reduce your taxable income in the year you contribute.
The investments within the account grow, tax-deferred, which means you don’t pay taxes on earnings until you withdraw the money, usually in retirement. This structure benefits individuals who expect to be in a lower tax bracket when they retire than when working. The key advantage of a traditional IRA is the immediate tax break on contributions, which can significantly reduce your tax liability each year you contribute.
How does a traditional IRA work?
A traditional IRA allows individuals to contribute pre-tax dollars, which can then be invested in various assets such as stocks, bonds, mutual funds and ETFs. The contributions and earnings grow tax-deferred, meaning you don’t pay taxes on them until you withdraw the funds, typically in retirement. This tax-deferred growth can result in significant savings over time, as the money that would have gone to taxes remains invested, compounding year after year.
When you reach the age of 59.5, you can start taking withdrawals without penalties, although the distributions will be taxed as ordinary income. At age 73, you must begin taking minimum distributions (RMDs) based on your life expectancy and account balance.
How an IRA benefits you
A traditional IRA offers several benefits:
Eligibility: Any working individual can set up and contribute to a traditional IRA, even before graduating high school.
Tax deduction: Contributions may be fully or partially tax-deductible, providing an above-the-line deduction that reduces taxable income without needing to itemize.
First home purchase: You can withdraw up to $10,000 for your first home without an early withdrawal penalty, though income taxes apply.
College expenses: IRA funds can be used for qualifying college expenses, including tuition, fees and supplies, without incurring the early withdrawal penalty, although taxes are owed on the withdrawals.
Traditional IRA deduction limits
The ability to deduct contributions to a traditional IRA depends on your income and whether a retirement plan at work covers you or your spouse. The limits are based on your adjusted gross income (AGI), which is your gross income minus specific deductions, such as student loan interest and certain retirement contributions.
Married filing jointly
| Adjusted gross income | Deduction limits |
|---|---|
| Below $123,000 | Full deduction |
| Between $123,000 and $143,000 | Partial deduction |
| Above $143,000 | No deduction |
Married filing separately
| Adjusted gross income | Deduction limits |
|---|---|
| Less than $10,000 | Partial deduction |
| Above $10,000 | No deduction |
Single filing
| Adjusted gross income | Deduction limits |
|---|---|
| Below $77,000 | Full deduction |
| Between $77,000 and $87,000 | Partial deduction |
| Above $87,000 | No deduction |
Traditional IRA taxes and penalties
Taxes on withdrawals: Withdrawals from a traditional IRA are taxed as ordinary income. The amount withdrawn is added to your taxable income for the year and taxed at your current rate.
Penalties: Early withdrawals (before age 59.5) generally incur a 10% penalty in addition to regular income taxes. However, there are exceptions for specific circumstances, such as first-time home purchases, higher education expenses and certain medical expenses.
How to open 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 it if you show 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. It's easy to open an account, and it does all the heavy lifting, so you don't have to actively manage your IRA.
1. Choose a provider: Select a financial institution or brokerage that offers traditional IRAs, considering factors like fees, investment options and customer service.
2. Complete the application: Provide personal information, including Social Security number, employment details and financial information.
3. Fund the account: Make an initial deposit and set up recurring contributions, if possible.
Traditional IRA rules
Eligibility: You must have earned income. There is no age requirement to contribute.
Contribution limits: $7,000 per year, with an additional $1,000 catch-up contribution for those aged 50 and older.
Tax-deductible contributions: Depending on income and whether covered by a workplace retirement plan.
Required Minimum Distributions (RMDs): RMD’s must start at age 73.
Early withdrawal penalties: A 10% penalty for withdrawals before age 59.5, with some exceptions.
Rollovers: Can be rolled over from other retirement accounts, maintaining tax-deferred status.
Limits and requirements
No early withdrawals
The most significant caveat of making contributions to an individual retirement account is that you can't touch your money too early, because withdrawals before age 59.5 can be costly.
The IRS will require you to pay a stiff 10% tax as a penalty.
Also, remember that withdrawals from your IRA will be counted as income. If you're still working, that money could bump you up to a higher tax bracket and result in you owing more money than expected at tax time.
Mandatory withdrawals post-retirement
That said, you can’t keep your money in your account indefinitely.
Once you turn 72, you must start making withdrawals — called required minimum distributions — or you’ll face a tax penalty of up to 50% of any amount you fail to take out as required.
The size of your required minimum distributions is determined by your account balance and a life expectancy table the IRS maintains.
You may not qualify for the tax deduction
Not everyone is eligible to deduct IRA contributions on their tax returns. Your income level, marital status and filing status can all make things tricky.
If you're single, you can get a full deduction up to the amount of your contribution limit, no matter how much money you make.
On the other hand? If, for example, you're married and filing separately with a spouse who is covered by a retirement plan at work, you'll get no deduction if your gross income is $10,000 or more.
Know before you open an account
Tax benefits: Contributions may be tax-deductible, reducing taxable income for the year.
Withdrawal rules: Withdrawals are taxed as ordinary income; penalties apply for early withdrawals.
Contribution limits: Understand the annual contribution limits and catch-up contributions if over 50.
Investment choices: Ensure the provider offers a range of investment options.
Required distributions: Be aware of the RMD rules starting at age 73.
Differences between a Roth IRA, a traditional IRA and a 401(k)
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. As part of your workplace benefits, a portion of the contributions you make to your 401(k) plan may be matched by your employer. That's as close as many people come to free money.
An IRA can be a good choice for self-employed people, freelancers and small business owners — basically anyone who doesn't have a pension plan or 401(k).
When choosing between a traditional IRA and a Roth IRA, ask yourself: What will my income (and tax bracket) look like when I retire? It seems counterintuitive, but your taxable income can actually go up after you retire.
So long as you think you’ll be in a lower tax bracket in retirement, it can make more sense to go with the traditional IRA. You’ll get tax benefits now and pay taxes at a lower rate later on.
And of course, even if you're employed by a company offering a 401(k) program, you may choose to have a traditional IRA and/or a Roth IRA as well.
FAQs
Chris Clark is freelance contributor with MoneyWise, based in Kansas City, Mo. He has written for numerous publications and spent 18 years as a reporter and editor with The Associated Press.
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