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Traditional IRA Definition
A traditional IRA (individual retirement account) is a retirement savings strategy that offers tax deductions or tax advantages to employees. In a traditional IRA plan, employees or individuals can do investment with their pre-tax income, that is, an individual can invest for future purpose which is tax-deferred.
The Employee Retirement Income Security Act of 1974 created the traditional IRA in the United States. Since its creation, this retirement savings plans has offered tax benefits to individuals because the IRS does not require any tax payment on this plan until the beneficiary withdraws from the plan at a due time. A retirement saver can open a traditional IRA through a brokerage firm, a local bank, mutual fund company or through a financial advisor.
A Little More on What is a Traditional IRA
Individuals or retirement savers can contribute pre-tax dollar amount into a traditional IRA account and such money can be used for investments which grows as tax-deferred until it is time for withdrawal. When retirement savers open traditional IRAs through their local banks, financial advisors, and retail brokers, the accounts are managed by these professionals and the funds therin used for investmnet purposes.
Contributions made to a traditional IRA is not tax-deductible until the time of withdrawal, this means capital gains or income taxes are no paid on money held in traditional IRA until an individual withdraws from the account. However, certain contributions may be tax deductible depending on the status of the tax filer or the income of the taxpayer.
There is a threshold for contributions that individuals can make into a traditional IRA account, depending on their age, income and status. As at 2019, retirement savers below the age of 50 cannot contribute more than $6,000 per year into the traditional IRA account, while individuals above 50 years can contribute up to $7,000 into their IRA accounts.
At the time of withdrawal from a traditional IRA account, the IRS deducts taxes from traditional IRA accounts using the ordinary income tax rate.
Here are some important points you should know about traditional IRA;
- Traditional individual retirement accounts (IRAs) are retirement savings accounts which permit individuals to contribute their pre-tax income and the income grow tax-deferred until the time of withdrawal.
- Capital gains or income tax are not deducted from traditional IRAs until individuals withdraw from the account.
- Individuals or retirement savers who are above the age of 70½ are no longer eligible to save in traditional IRA accounts.
- The IRS uses the ordinary income tax when a traditional IRA account is to be taxed at the time of withdrawal.
Traditional IRAs and 401(k)s or Other Employer Plans
In some cases, employees use traditional IRAs in place of employer-sponsored retirement plans while certain employees have the combination of traditional IRA and an employer-sponsored retirement plan such as 401(k). The IRS limit the amount individuals that can contribute to traditional IRAs when they have both IRAs and an employer-sponsored retirement plan. All the limits, modifications and deductions by the IRS are outlined and can be assessed by retirement savers and other individuals.
Traditional IRA Distributions
The withdrawal time refers to the time that retirement savers receive distributions from a traditional IRA. this is also the time the distributions received are taxed by the IRS. The IRS treat such income as ordinary income, hence, ordinary income tax rate is applicable. One retirement savers are 59½ of age, they can make withdrawals from a traditional IRA and are no longer eligible when they are 70½ but they can only take required minimum distributions (RMD) from their traditional IRAs.
When individuals make withdrawal from a traditional IRA before their eligibility period, there attract a 10% penalty. Withdrawals that are exempted from such penalties are withdrawals made to;
- Rebuild or purchase a first home for the saver or family member.
- Settle higher-education expenses.
- Settle medical insurance after the saver loses their job.
- Money withdrawn when the saver becomes physically challenged or after the death of the saver are also exempted.
Traditional IRAs versus Other IRA Types
Aside from traditional IRAS, there are other types of IRAs which are;
- Roth IRA
- SIMPLE IRA
- SEP IRA
SIMPLE IRA and SEP IRA are employer-based accounts while Roth IRAs are set up by individuals that meet the income limitations set up by the IRS. A Roth IRA does not offer retirement savers many benefits as those offered by traditional IRA, both IRAs can however be opened by individuals through their retail broker, commercial bank or a mutual fund company.
Also, in a Roth IRA, required minimum distributions (RMDs) do not exist on accounts unlike in a traditional IRA where an account holder will have to take required minimum distributions (RMDs) once they are 70½.
Furthermore, contributions made to Roth IRAs are not eligible for tax deductions except for some distributions that are tax-free. On the other hand, SIMPLE IRAs and SEP IRAs are created by employers, these IRAs have higher limits than other forms of IRAs. self-employed individuals or proprietors of small businesses can also open SIMPLE IRAs and SEP IRAs. contributions made into these accounts by employers are eligible for tax deductions and the deduction scan vary from one employer to another based on the discretion of the IRS.
References for “Traditional IRA”
Academic research for “Traditional IRA”
Comparing a traditional IRA and a Roth IRA: Theory versus practice, Adelman, S. W., & Cross, M. L. (2010). Comparing a traditional IRA and a Roth IRA: Theory versus practice. Risk Management and Insurance Review, 13(2), 265-277.
CONVERTING A TRADITIONAL IRA TO A ROTH IRA: BREAK-EVEN ANALYSIS., Clayton, R. J., Davis, L. W., & Fielding, W. (2012). CONVERTING A TRADITIONAL IRA TO A ROTH IRA: BREAK-EVEN ANALYSIS. Journal of Personal Finance, 11(2).
[PDF] In Defense of the Traditional IRA, Higgins, C. J. (2013). In Defense of the Traditional IRA.
Converting to a Roth IRA with Taxes Paid from Corpus of the Traditional IRA, Clayton, R., Clayton, L., Davis, L., & Fielding, W. (2014). Converting to a Roth IRA with Taxes Paid from Corpus of the Traditional IRA. Journal of Applied Finance (Formerly Financial Practice and Education), 24(1).
Embedded options and tax decisions: A reconsideration of the traditional vs. Roth IRA decision, Hulse, D. S. (2003). Embedded options and tax decisions: A reconsideration of the traditional vs. Roth IRA decision. Journal of the American Taxation Association, 25(1), 39-52.
Reconsidering IRA and Roth IRA: Keeping bequests and other options in mind, Al Zaman, A. (2008). Reconsidering IRA and Roth IRA: Keeping bequests and other options in mind. The Journal of Wealth Management, 11(2), 82.
The influence of automatic enrollment, catch-up, and IRA contributions on 401 (k) accumulations at retirement, Holden, S., & VanDerhei, J. (2005). The influence of automatic enrollment, catch-up, and IRA contributions on 401 (k) accumulations at retirement.
Investment performance comparison between Roth and traditional individual retirement accounts, Kutner, G., Doney, L., & Trebby, J. (2001). Investment performance comparison between Roth and traditional individual retirement accounts. Journal of Applied Business Research.
Myths and Truths of IRA Investing., Caliendo, F., & Lewis, W. C. (2002). Myths and Truths of IRA Investing. Journal of Financial Planning, 15(10).
Federal budget rules: the US experience, Auerbach, A. J. (2008). Federal budget rules: the US experience (No. w14288). National Bureau of Economic Research.