Traditional IRA Tax Advantages
Deciding what type of an Individual Retirement Account (IRA) to invest in may require a little deciphering to determine what works best for you. If you are expecting to be in the same or a higher tax bracket when you retire as you are now, then you may want to consider contributing to a Roth IRA which will allow you to pay your taxes now.
Is a traditional IRA the best choice for your needs?
There are income limits for Roth IRAs, so if your income is above the limits that allow you to contribute, then it's a no-brainer: a traditional IRA is your only choice.
Should you be eligible for both a Roth and a traditional IRA, then it's time for you to run some numbers to determine which fits you best.
For tax purposes it is generally better to choose a traditional deductible IRA if you expect to be in a lower income tax bracket once you are ready to retire. There is no doubt that it can be a pig in a poke guessing what tax bracket you will be in many years from now when you retire - especially the way time and technology promote career changes.
With a traditional tax-deferred IRA retirement savings account you pay taxes on your money as you make withdrawals during retirement. By deferring taxes you can allow your capital gains, dividends, and interest payments to compound each year without being hindered by taxes. This allows your IRA to grow at a much faster pace than a taxable account where you continually pay taxes as income is earned.
Are you expecting to retiring in a lower tax bracket?
With a traditional IRA you can begin deducting your contributions now and lower your current tax bills accordingly. Once you retire and start withdrawing money from your IRA, if you are in a lower tax bracket, you will be giving less money overall to Uncle Sam.
With a traditional IRA you can begin withdrawing funds whenever you want. However, you will be paying regular income taxes on the full amount if you are under age 59½ when you make the withdrawal. You will also be charged a 10% penalty in addition to paying your regular income taxes owed. Making early withdrawals is generally a bad financial move for your retirement funds and for current tax bills.
When must you start withdrawing from your traditional IRA account?
You can begin making qualified withdrawals from a traditional IRA at the age of 59½. However, you must start taking "required minimum distribution" withdrawals starting in the year that you turn 70 ½ years old.
The amount of the required distribution depends entirely on how much you have saved in your IRA account along with your life expectancy, according to tables published by the IRS.
Types of Traditional IRA's
Traditional IRAs are available in two varieties:
- Deductible Traditional IRA: A deductible IRA allows you to lower your tax bill by deducting your contributions on your tax return - essentially you get a refund on the taxes you paid earlier in the year.
- Nondeductible Traditional IRA: The way you fund a nondeductible IRA is with after-tax dollars. You cannot deduct these contributions on your tax return.
It's pretty obvious that a deductible IRA is a better investment. However, qualifying to contribute to one depends on your income, filing status, whether you have access to an employee-sponsored retirement plan through your employer, and whether you receive Social Security benefits.
Who can contribute to a traditional IRA?
If you (or your spouse) earn taxable income and are under age 70 ½, you can contribute. It's as easy as that.
However, whether your contributions are tax deductible depends on your income and whether you have access to a work-related retirement account. Here are the IRA contribution guidelines for 2019 - 2020. IRA contribution limits may vary on an annual basis so it is a good idea to check the allowed contribution figures each year.