Traditional IRAs are one of my favorite investment vehicles. 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 IRAs, but I’m a big fan of the traditional variety. You may also be familiar with Roth IRAs.
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 IRAs 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. Traditional IRAs are Tax Advantaged
All capital gains and dividends earned within a Traditional IRA are protected from taxation until the time of withdrawal. And if you withdraw in lower income years, you will receive a lower tax rate on that income.
3. Traditional IRAs are Flexible
You can contribute to a traditional IRA at any point during the year. The 2020 and 2021 maximum IRA contributions are $6,000, respectively. 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 make my 2020 contributions up until mid April of 2021.
Where this comes in particularly handy is when you realize that by contributing more towards your IRA, you are able to lower your taxable income, which can have big strategic advantages. In being able to contribute up until the tax deadline of the following year, this retroactive contribution rule allows you extreme flexibility at the time of completing your tax return.
4. Capital Gains are Not Taxed within a Traditional IRA
You heard right. The capital gain and dividends income you receive is 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 401Ks Directly into a Traditional IRA without Tax or Penalty
If you have one or more 401Ks 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.
Final Thoughts on Traditional IRAs
Start a traditional IRA sooner than later – as they are among the best retirement accounts you can open. 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!
- 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?