An Individual Retirement Account (IRA) is one of the building blocks of retirement planning. It’s a type of savings account designed specifically for retirement, with certain tax advantages. This chapter will focus on one of the two main types of IRAs – the Traditional IRA. We’ll look at the characteristics of a Traditional IRA, who is eligible, how much you can contribute, and the tax implications of contributions and withdrawals.
What is a Traditional IRA?
A Traditional IRA is a tax-advantaged retirement account. In most cases, the money you contribute to a Traditional IRA is deductible on your tax return, which means you could lower your tax bill in the year you make the contribution. The earnings on your contributions grow tax-deferred, meaning you won’t owe any taxes on the gains until you start taking money out of the account in retirement.
One of the significant benefits of a Traditional IRA is the immediate tax deduction. However, it’s essential to understand that when you start withdrawing funds in retirement, those withdrawals will be subject to income tax.
Who is Eligible?
Just about anyone with earned income can contribute to a Traditional IRA. However, there are income limits that determine whether you can deduct your contributions. If you or your spouse have a retirement plan at work, such as a 401(k), the ability to deduct your contributions to a Traditional IRA begins to phase out above certain income levels. For those without a retirement plan at work, the deductibility of contributions is not subject to income limits.
The key is to understand your eligibility for tax-deductible contributions based on your income and work retirement plan status. If you’re ineligible for a deductible contribution, you might be better off considering other retirement account options, like a Roth IRA, which we’ll explore in the next chapter.
Every year, the IRS sets limits on how much you can contribute to a Traditional IRA. For 2023, the maximum contribution is $6,000 if you’re under age 50. Once you reach the age of 50, you’re allowed to make an additional “catch-up” contribution of $1,000, raising the total limit to $7,000.
It’s crucial to note that these limits apply to the total contributions to all your Traditional and Roth IRAs combined. So if you have multiple IRAs, you’ll need to make sure your total contributions don’t exceed the maximum limit.
Here’s a quick reference table for the IRA contribution limits for 2023:
|50 or older||$7,000|
Tax Implications of Withdrawals
While Traditional IRA contributions provide a tax benefit upfront, withdrawals in retirement are taxed as ordinary income. This includes both your original contributions and any investment earnings.
One key rule about Traditional IRAs is that you must start taking required minimum distributions (RMDs) once you reach age 72, even if you don’t need the money. The exact amount of the RMD depends on your age and the total balance in your IRA.
The key takeaway here is to remember that while a Traditional IRA can provide a tax advantage when you contribute, it’s equally important to plan for the tax implications when you start to withdraw in retirement. In the next chapter, we’ll discuss Roth IRAs, which have a different tax structure and might be a more suitable option depending on your circumstances.