5 Reasons why Everyone Needs a Traditional IRA
Traditional IRA’s are my favorite investment vehicle. Why? They are highly flexible. If you don’t have one, you should. They are easy to set up and depending on the broker, they are typically free of fees. Before I get into the benefits of a traditional IRA, let’s get into the basics of what they are.
What is a Traditional IRA?
IRA stands for ‘individual retirement account’. An IRA is an investment vehicle that basically serves as a shell account, allowing you to purchase actual investments such as mutual funds, stocks, and bonds. If you’d like, you can simply keep your contributions in cash and earn interest on it. There are a few different types of IRA’s, but I’m a big fan of the traditional variety. You may also be familiar with Roth IRA’s.
The Main Difference Between a Traditional IRA and a Roth IRA
I have previously covered the big differences between a traditional 401k and a Roth 401k. The differences between a traditional IRA and Roth IRA are similar to their 401K brethren. Essentially, any contributions to a traditional IRA are tax deductible. You are taxed when you pull out distributions in retirement. A Roth IRA taxes you now and you do not pay any taxes upon retirement.
5 Reasons why Everyone Should have a Traditional IRA
1. Traditional IRA’s are Tax Deductible
You are allowed to subtract your traditional IRA contributions from your amount of taxable income. This leaves you more money and lowers your taxes now, at a time when you could possibly need the tax breaks more than in retirement (with the Roth).
2. Where Should I Start a Traditional IRA?
I’m a huge fan of because they have zero IRA maintenance or annual fees. You may also want to give Zecco a look because they have $0 stock trades.
3. Traditional IRA’s are Flexible
You can contribute to a traditional IRA at any point during the year. The contribution limit is $5,000 per year for 2008 and 2009. You can contribute to a traditional IRA for any given tax year up until the the tax deadline (mid April) of the following tax year. For instance, I could contribute to my 2008 contributions up until mid April of 2009.
Where this comes in particularly handy is when you realize that by contributing more towards your IRA, you might actually be able to kick yourself down into a lower tax rate bracket. All but the strictest planners know how much of a contribution will kick them down into a lower tax bracket before it comes time do your taxes. This retroactive contribution rule allows you extreme flexibility.
4. Capital Gains are Not Taxed within a Traditional IRA
You heard right. The 15% you are being taxed on capital gains and dividends (not much of a worry this year, I realize), are not taxed within a traditional IRA. This allows you to build your nest egg much faster than a taxable account.
5. You can Roll your 401k’s Directly into a Traditional IRA without Tax or Penalty
If you have one or more 401k’s sitting around from previous jobs and you are finding it a hassle to keep track of everything, you can roll them over tax and penalty free into a traditional IRA. Consolidation can be a beautiful thing.
6. You can Withdraw Funds from an IRA
Not that you’d WANT to, but if you NEED to, you may pull out your contributions and use them in an emergency. Many people incorrectly think that you cannot access these contributions at all until you reach retirement age. You can, but you will be taxed (as you received deductions previously). You will also pay a 10% early withdrawal penalty.
Final Thoughts on Traditional IRA’s
Start a traditional IRA sooner than later. The odds are that you will need to at some point, so why not start reaping the benefits now? If you already have one, make the most of it!
IRA Discussion:
- Do you have a traditional IRA? a Roth IRA?
- If you don’t, will you be getting one?
- What clever ways are you taking advantage of your traditional IRA?
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You may also find the following articles of interest:
The Complete Guide to Choosing Between a Traditional 401K and a Roth 401K
IRS 401K Maximum Contribution Limits
Someday when I make enough money to contribute to my 401(k) AND max out my Roth, then I’ll consider this. Right now, though, I make less money than I plan on having per year in retirement, so it doesn’t make sense for me to be contributing any more than my employer match (which is a fairly significant amount) to a tax-deferred account. Next year I will either start grad school OR plan on maxing out my Roth (probably can’t afford both!), so I guess in 2010 I will come back and reference this article! I like having this opportunity to start thinking ahead though!
@ Stephanie – absolutely, everyone should get their max match before even contributing to a non-matched account like IRA’s. Question out of curiosity: why max out your Roth before contributing to a traditional IRA? People have different reasons, so I’m just wondering.
This year I will make under $25k (before taxes). I work in Residence Life on a college campus, so this isn’t as bad as it sounds – I have full campus benefits (excellent insurance, great match on 403(b), can take 6 credit hours free each semester, etc.) and rent, utilities, internet, etc. are included in my “benefits package,” since I’m required to live on campus for my job. After grad school (a one year program that I’ll start either next fall or the following fall), I’ll be making significantly more money (probably 3X as much or more) in my “real” career. I plan on having enough saved for retirement to pull well over $25k out each year. So, I think it works out better for me to pay taxes right now (especially since I pay so little in taxes anyway, due to having such a small income!) so that I can pull all of my principle and interest out tax-free later when I’ll be “making” more money.
There is definitely a time and place for both products. In my case I plan on being retired by the time I can withdrawal from a traditional IRA penalty free. That would mean making tax free contributions during working and high tax bracket years. Once retirement roles around it’s time to cash in the traditional IRA at a much lower tax rate.
Not sure agree with your conclusions, or the exclusivity of the benefits of a traditional IRA over that of the Roth IRA. Especially for those in their 20s. Generally, it seems safe to assume that younger people will be in a higher tax bracket upon retirement… thus the tax benefits now are often outweighed by receiving distributions at a higher taxable rate. Plus traditional IRAs also have tax risk involved. With an IRA, you know the rate you are taxed on contributions…. but in 40+ years when your withdraw your traditional IRA, the relevant tax rate could be different– either higher (ugh), or lower (great!).
It is true that capital gains are not taxed with a traditional IRA. Capital gains are not taxed until the capital gain is realized… that is, upon sale. BUT IRA distributions are taxed as ordinary income…. and the Roth will be tax free in that capacity, provided you follow all requirements.
You can roll directly into a Roth IRA… if you have a Roll 401(k). The only “penalty” is the applicable tax rate. Personal choice on whether or not to take that hit now or later.
The same flexibility, I believe, largely applies to Roth IRAs, in timing of contributions… though for tax upfront purposes, it is largely not relevant. With a Roth IRA, you can withdraw your contributions–not additional earning, though–at any time, without penalty.
So no, I wont’ be getting a traditional IRA until my income reaches a level that I no longer qualify for Roth IRA contributions, or that the later tax benefit is no longer worthwhile compared to the immediate benefit. I strongly recommend other 20 somethings consider this strategy as well. But each persons situation is different, so if in need of advise, do some reading through reputable (not a slight at this blog at all…. I read it often) sources or contact and advisor.
@ Stephanie – sound strategy.
@ Rob, Ryan – This post was not a “why traditional IRA’s are superior to Roth IRA’s post”, nor was it meant to compare the benefits of each to the other. I think Roth IRA’s are great as well, and I have one. This post was to merely point out the benefits of a traditional IRA. There are certainly unique aspects to a traditional that can only be gained from having one, as I’ve listed. I could just as easily create a “5 Reasons why” post for Roth’s, and that may be coming down the road. Thanks for adding to the discussion.
@ Ryan,
You have some very good and valid points. The idea I’m trying to convey is that if I’m already retired or not working by age 59 1/2 capital gains and income taxes will be much lower on a traditional.
Thanks for the explanation. I do not know much about the difference so this was a big help. It seems there are a lot of advantages to a traditional IRA. I’m sure there are advantages to the other types of retirement fund as well. Maybe a follow up article could have a basic pros/cons lists of each. I had a traditional IRA set up with a former job, and now with my new job I don’t have anything set up through the company. To be honest I kind have lost contact with anything involving that former IRA account and don’t know even where to begin to find out more about it and what to do next. Any advice?
Craig
http://www.budgetpulse.com
It is true that capital gains are not taxed with a traditional IRA. Capital gains are not taxed until the capital gain is realized… that is, upon sale. BUT IRA distributions are taxed as ordinary income…. and the Roth will be tax free in that capacity, provided you follow all requirements.
Ryan is right on! There is really almost no reason why a 20-something would want a Traditional over a ROTH. The big reason is that all 20-somethings will need to wait 30-something years before they are eligible to start taking out substantial sums of their retirement.
That means the money is going to have a LONG time to grow. For instance 20k invested for 33 years at 5% annual growth comes out to around 100k.
If that money were in a traditional IRA you would pay ordinary income tax on the full 100k!!! Ouch! Right now that would mean losing about $35,000 in taxes.
If you had put that 20k in a Roth… and paid the 4k in taxes now. Then the money grows to 100k. When you retire you get to take the full 100k whenever you want with no tax worries.
That’s a huge, huge, huge difference now.
And as for this quick last minute traditional IRA contribution to lower your tax bracket and save money… it’s basically crap.
Here’s a scenario to illustrate this point:
This article makes it sound like if you made 35k you would pay ($35,000 x 0.25 = $8,750) in taxes. Then they would have you think that if you pay 3k into your traditional IRA you would drop your income to 32k for the year, which puts you in the 15% tax bracket. So you would pay ($32,000 x 0.15 = $4,800) in taxes. So by contributing 3k to a traditional IRA you were able to lower your tax bracket and save ($8,750 – $4,800 = $3,950) in taxes. If this actually is how taxes were calculated it would be great and this would work…
But our taxes are calculated on a tiered system. If you make 35k a year you will pay in taxes:
$8,025 x 0.10 = $802.50 +
$24,525 x 0.15 = $3,678.75+
$2,450 x 0.25 = $612.50 = $5,093.75
If you put the 3k in your traditional IRA you now have a taxable income of 32k, right… and the total taxes on that are:
$8,025 x 0.10 = $802.50 +
$23,975 x 0.15 = $3,678.75 = $4,481.25.
So you can see how you have paid $3,000 into your IRA, but you only lowered your tax liability by $612.50
It is a tiered system. On the first $8,350 everyone pays 10% taxes, then on the next $25,600 everyone pays 15% taxes, and on the next $48,300 everyone pays 25% taxes.
With my personal finances, I find a Roth IRA to be a better.
Since the contribution limits are the same for both the Traditional IRA and the Roth IRA, if you’re able to contribute to both, the tax deductibility of a Traditional IRA actually works against it.
Why?
Because when I go to withdraw my money from a Roth, I don’t have to pay taxes. But with a Traditional IRA, I will have to pay taxes upon withdrawal.
So even though I laid out more cash initially to fully fund my Roth IRA, I end up with more in retirement because the funds in my account will be free and clear of taxes.
That said, once I pass the phase-out income limit for contributing to a Roth, a Traditional IRA will be preferable over a regular brokerage account…
I agree that everybody should have an IRA. The problem is that many folks just cannot afford to contribute. I agree that Roths can work well for some people, but you need to have the money to begin with.
Thanks for the explanation.
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