How a traditional IRA works

In simple 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.

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. You may even be able to get a tax write-off for your contributions, to boot.

Many types of investments are OK inside an IRA, including stocks, bonds, ETFs and mutual funds. The gains in the value of those investments will be tax free, too.

Because it's such a potent tool, the government establishes limits on how much you can contribute each year.

For 2022 — and for the last few years going back to 2019 — that annual limit has been $6,000, or $7,000 if you're over age 50. That figure is shared among all of your traditional and Roth IRA accounts.

When the 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.

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Benefits of a traditional IRA

Anyone is eligible

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

Depending on your income and whether you or your spouse is covered by a retirement plan at work, your IRA contributions may be partly or fully tax deductible.

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

Money for your first home

You can withdraw $10,000 of your IRA investments toward the cost of your first home. You’ll face income taxes on the withdrawal, but won’t be subjected to an early withdrawal penalty.

Money for college

Similarly, you can use your IRA contributions to pay for qualifying college expenses — not just tuition but fees, books, supplies and more.

Again, you’ll face taxes on the withdrawal, but won’t have to pay the penalty.

Limits and requirements

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% 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 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.

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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.

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. It's easy to open an account, and they do all the heavy lifting so you don't have to actively manage your IRA.

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About the Author

Sarah Cunnane

Sarah Cunnane

Former Staff Writer

Sarah Cunnane was formerly 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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