What is…a Traditional IRA?
“IRA” stands for Individual Retirement Account, and there are all different kinds of IRAs depending on what you’re trying to accomplish. We’re not going to go through all of the types of IRAs in this post, though, we’ll break it down and start with the Traditional IRA.
First, an IRA isn’t an investment, so opening one and throwing money into it won’t automatically mean it’s going to grow when you hear someone on the news say “The Dow hit a new all-time high today!” (We’ll talk about what “The Dow” and “The S&P 500” mean later.)
Instead, think of an IRA as an empty apple cart. In fact, all your accounts are empty apple carts!
| Traditional IRA||401(k) / Employer Plan||Nonqualified Brokerage|| Savings Account|
The Traditional IRA apple cart is just a holding place for your apples (which are dollars in this metaphor). If you put the apples directly into the cart they’ll just roll around aimlessly, and will get bruised and be worth less in the future. This is like putting dollars into your Traditional IRA without investing them, because they’ll literally be worth less in the future when we factor in inflation. We’ll talk about what investing those dollars really means in another post.
The Technical Stuff…
Now that you know the Traditional IRA is just an empty cart ready to fill with apples ($$), there are several other important things to know. First, the money you put in, known as contributions, are tax-deferred. That means you don’t pay taxes on the money you put into your Traditional IRA. Instead, when you file your taxes for the year, you’ll deduct the amount that you put into your Traditional IRA straight off of your income. The “deferred” part also means that you’ve deferred paying taxes to a later date, because you will pay taxes when you take the money out in retirement as if it was regular income.
How much can I contribute?
Next, there are limits to how much you can put into your Traditional IRA each year, since you know that the Internal Revenue Service (a.k.a. the IRS, a.k.a. “the Tax Man”) doesn’t want you to deferring taxes on any more income than necessary. The amount you are allowed to contribute is based on how much you earn, and the limits are different for single tax filers, couples who are married filing jointly, and couples who are married filing separately.
The IRS has a handy-dandy chart that explains exactly what the limits are for different income and tax filing scenarios:
- One for people who are covered by a retirement plan at work (like a 401(k), 403(b), etc.)
- Another chart for people who are not covered by a retirement plan at work, and people who are married but only one spouse is covered by a retirement plan at work
The maximum you are allowed to contribute in 2020 and 2021 at the very most (based on where you fall on the IRS charts), is $6,000 for people age 49 and under, and $7,000 for people age 50 and over. Also important is the fact that if you make less than $6,000 (or $7,000 if you’re over age 50), you can only contribute as much as you earned. For example, if you’re age 65 and working part-time at a yarn shop (tackle shop, button store, museum, wherever) and earned $5,000, you can only contribute up to $5,000 to your IRA. If you’re married, you can contribute to your IRA and your spouse’s IRA, meaning if you made $12,000 at your part-time job at the button store, you can contribute $7,000 to your IRA and $5,000 to your spouse’s IRA (or $6,000 each if you want to keep it even, the breakdown isn’t regulated).
What if I need to use my money before retirement?
The money you save into your IRA is really, really supposed to be for retirement according to the IRS. There are some exceptions to the withdrawal penalties (we'll discuss those in more detail later), but for the most part, you will pay income taxes plus a 10% penalty tax if you take money out of your Traditional IRA before you reach age 59 ½ (to the day. Don’t take it out even one day before your half-birthday or you’ll pay the penalty tax. Bye bye money!).
What are RMDs?
Lastly, with a Traditional IRA, you’ll have to take what are called “Required Minimum Distributions” or RMDs when you reach age 72. The IRS has a specific calculation to determine the required amount based on your age each year, and the investment company who holds your IRA should provide you with the amount you have to take. You’ll have to take your RMD before December 31st each year, and if you’re late or you don’t take enough out you’ll pay a 50% penalty tax on the shortage. (Example: if you were supposed to take $10,000 in 2020 and you completely forgot, you’ll have to take the $10,000 out in 2021, pay income taxes on it, and a $5,000 penalty tax too. OUCH. And then don’t forget to take your 2021 RMD!)
There are other details and intricacies that you may need to know, so don’t treat this post as the only resource you need when opening a Traditional IRA, but it should get you pointed in the right direction. You might be wondering about the other kinds of IRAs now, so here’s the reading list!
- What is…a Roth IRA?
- What is…a SIMPLE IRA?
- What is…a SEP IRA?
- What is…a Coverdell IRA?
- What is…an Inherited IRA?
- What is…a Rollover IRA?
Juncture Wealth Strategies cannot and does not provide tax or legal advice. For specific advice on these aspects of your overall financial plan, you should consult your tax advisor or attorney. This is provided as a summary only and does not guarantee accuracy.