Saving for your retirement is one of the most important things you can do for yourself. I talk about building savings all the time, but if you find yourself wondering exactly what to do with the money you’ve been setting aside, you’re not alone. Retirement planning is a billion-dollar industry, and there are lots of products to choose from. In this first post of a new series, we’re going to explore the traditional IRA: its benefits, drawbacks, and all the rules you need to follow.
What Is a Traditional IRA?
An IRA is an Individual Retirement Account that anyone can open to put money aside for retirement. It’s called a traditional IRA to differentiate it from the newer Roth IRA (which we’ll talk about next time).
What sets an IRA apart from other investment accounts is that it has important tax advantages. First, the amount you contribute to your traditional IRA each year is tax deductible, meaning that you won’t pay taxes on that money this year. This can help you boost your tax refund or offset any taxes you owe on a side gig, so it’s a huge incentive to open this type of retirement account.
Second, your investments can grow without being taxed. This is different from a typical brokerage account, which will send you paperwork every year to submit to the IRS to calculate capital gains taxes. Money in a traditional IRA is only taxed when you take distributions, or withdrawals, after you retire.
Traditional IRA Rules
Because IRAs are so generous when it comes to the tax breaks, there are limits to how much you can invest and rules you have to follow to reap the benefits:
- For people under age 50, you can only invest $6,000 per year.
- For people between age 50 and 70, you can invest $7,000 per year.
- You can’t invest after age 70 1/2.
- If you take money out of your account before age 59 1/2, you’ll have to pay income taxes at your regular rate, plus a 10% penalty on the amount you withdraw.
Finally, it’s important to understand that a traditional IRA is a tax-deferred account, not a tax-free account. Even though you aren’t paying taxes on your investments right now, you will have to pay income tax on the money you take out of the account when you retire. For example, if you take a distribution of $1,000 per month, you’ll owe taxes on a total of $12,000 of income at the end of the year. This is paid when you file income taxes during retirement.
The Benefits of Traditional IRAs
- You don’t pay income taxes on the money you invest in a traditional IRA (for now).
- Your investments aren’t taxed until retirement, allowing you to reap the full benefits of compound interest as your savings grow exponentially over time.
- If you live frugally during retirement, you may owe less in taxes later than you would now, especially if you’re in your peak earning years.
- You can create a comfortable nest egg for yourself, particularly if you start investing early.
The Drawbacks of Traditional IRAs
- Money in your retirement account is unavailable for emergencies, unless you’re willing to pay a hefty penalty for taking it out early.
- You will have to pay taxes during retirement, and this can complicate your planning.
- Because you have to take money out of your account starting at age 70 1/2, you could be pushed into a higher tax bracket if you’re still working.
- If you’re a super-saver, you might max out a traditional IRA and need other more options for savings.
For most people, a traditional IRA is a great way to get started on the road to a secure financial future. The tax breaks now help you grow your money wisely, and most people are willing to follow the rules about penalties and distributions in exchange for that deal.