How traditional IRAs work

You can start saving for retirement, whether or not you have a work-sponsored plan.

Elissa

Elissa Suh

Published May 31, 2019

KEY TAKEAWAYS

  • An IRA is an individual retirement account

  • You can have both an IRA and a 401(k)

  • Traditional IRA contributions are tax-deductible, and you only pay income tax on withdrawals

  • As of 2019, the IRA contribution limit is $6,000 if you're under age 50, and $7,000 if you're 50 and above

Many workplaces offer a retirement savings plan, like a 401(k), for their employees. But if they don't, that doesn't mean you can’t start saving for retirement on your own. That’s where a traditional IRA comes into play. An IRA is an individual retirement account that you can open and fund on your own. Even if you do have another employee-sponsored retirement plan, such as a 401(k), you can still augment your savings by funding an IRA.

Traditional IRA contributions are tax-deductible for the year you make the contribution. You will only pay income taxes on your withdrawals from a traditional IRA, unlike the Roth IRA, which is funded with after-tax dollars. We’ll discuss more differences between a traditional IRA and a Roth IRA or 401(k), and more.

In this article:

Traditional IRA vs 401(k)

A traditional IRA has similar structure and features as your standard 401(k). The biggest differences are that IRAs have a much smaller contribution cap than 401(k)s, and tend not have an employer-match program.

Individual retirement arrangements (both traditional and Roth) also offer special circumstances in which you can withdraw your earnings without any penalties before age 59 ½. These include a first-time purchase of a house, a qualified educational expense, or a disability-related withdrawal.

Early withdrawals from a 401(k) will incur an additional 10% tax unless you can prove financial hardship. You can read more about how 401(k)s work, and examine the chart below for comparisons at a glance.

Traditional IRA401(k)
How to qualifyEarn taxable incomeMust be offered by employer
Income requirementNoneNone
Contribution limit$6,000 (as of 2019)$19,000 (as of 2019)
How you contributePre-tax dollarsPre-tax dollars
How your money growsTax-deferredTax-deferred
Investment optionsFlexibleLimited by plan
Penalty-free withdrawalsBegin at age 59 ½Begin at age 59 ½
Required minimum distributions (RMDs)Begin at age 70 ½Begin at age 70 ½

How a traditional IRA works

When you open a traditional IRA account, you’ll need to fund it by making contributions, which you can claim as a tax deduction to lower your taxable income. But, depending on your income level and whether or not you have a work plan in place, there will be limits as to how much of your contribution you can deduct.

Next, you’ll manage your investments options and how hands-on you want to be during the investment process. The IRA’s flexible offerings include stocks, bonds, CDs, and more. You can choose what to invest in by yourself or use a robo-adviser.

The money you invest will grow tax-deferred until retirement, and at age 59 ½ you can begin to make penalty-free withdrawals, known as distributions. At this point, you’ll pay income tax on those distributions. But you might be in a lower tax bracket at the time of retirement, compared to when you originally made the contributions, so you’ll be saving money in the long run by paying less income tax.

Once you reach age 70 ½, you can no longer contribute to your IRA and will be forced to make withdrawals, called required minimum distributions (RMDs). You can use the IRS worksheet to calculate your RMD.

Traditional IRA vs Roth IRA

Traditional IRAs are similar to Roth IRAs, with the main difference being how they're funded and when the gains are taxed. Roth IRAs are funded by after-tax contributions, so the money grows tax-free in the account, and any distributions you take will not incur income tax after age 59 ½ and you’ve held the account for more than five years.

A Roth IRA can benefit you if you think you'll end up in a higher tax bracket when you retire. You'll be saving money since your withdrawals will be taxed at a lower marginal tax rate.

Read more about the Roth IRA and how it compares to a traditional IRA here.

Do I qualify for a traditional IRA?

You only need a taxable earned income to open an IRA. If your income is comprised of rent payments, investment income, social security benefits, or unemployment wages you cannot contribute to an IRA.

There are no income limits for opening or funding a traditional IRA like there are with the Roth IRA, but there are income limits as to how much you of your contribution is tax-deductible.

You can open a Roth IRA at a bank or credit union, an asset-management company, or online brokerage.

Common IRA providers are:

  • Fidelity Investments
  • Vanguard
  • Charles Schwab
  • T. Rowe Price

Common online brokerages are

Traditional IRA tax deductions limits

The government offers tax deductions for traditional IRA in the hopes that consumers will use the savings to stow away into a retirement plan.

To take advantage of these deductions, you’ll have to meet some income eligibility requirements. Once your modified adjusted gross income. reaches a mount, your deductions will be reduced, or phase out. based on your

If you have a workplace plan

For single filers:

Modified AGIDeduction
$64,000 or lessFull
Between $64,000 and $74,000Partial
$74,000 or moreNone

For married filing jointly or qualifying widowers:

Modified AGIDeduction
Less than $103,000Full
Between $103,000 and $123,000Partial
$123,000 or moreNone

For married filing separately:

Modified AGIDeduction
Less than $10,000Partial
$10,000 or moreNone

If you don’t have a workplace plan

You can take the full deduction up to your contribution limit regardless of your income level if:

  • You’re a single filer, head of household, or qualifying widow(er).
  • You’re married, whether filing jointly or separately, and your spouse does not have an employer-sponsored plan.

If you’re married, filing jointly, but your spouse has a workplace plan:

Modified AGIDeduction
$193,000 or lessFull
Between $193,000 and $203,000Partial
$203,000 or moreNone

If you’re married filing separately, but your spouse has a workplace plan:

Modified AGIDeduction
Less than $10,000Partial
$10,000 or moreNone

How much can I contribute?

  • If you’re under 50, total IRA contribution limits are $6,000.
  • If you’re age 50 or older, you can contribute up to $7,000.
  • You cannot make contributions after age 70 ½.
  • For the 2019 tax year, the IRA contribution deadline is April 15, 2020.
  • Annual IRA contributions are capped for across all types of IRAs. If you already contributed $5,000 to your Roth IRA, then you can only fund $1,000 into your traditional IRA.
  • Your contribution amount can only be as much as your earned income. If your earned income for the year was $5,000, then you can only contribute $5,000 at maximum.
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How much should I contribute?

Studies show that most people don't have enough saved for retirement. How much you can contribute determines on your circumstances and your savings goals.

Let’s say you’re 30 years old and started contributing $3,000 annually to a traditional IRA for thirty years. When you’re 60 years old, your IRA account balance will be over $251,000 with a modest 6% rate of return.

Now let’s say you contributed a little more — the maximum $6,000 annually for thirty years. With the same 6% rate of return, your IRA account balance would be over $502,000.

Keep in mind that when you turn 50 years old, you can contribute an additional $1,000. That means you could even earn more than the above examples, if you max out you’re IRA contribution.

How much money does a traditional IRA earn?

How much money you make from your IRA depends on how you choose to invest. Some assets are riskier than others and provide higher returns. Certificates of deposit (CDs), for example, are steady, low-risk investments. This is reflected in the rate of return, or how much you earn, which is just around 3% for CDs.

The return on CDs might be lower than stocks, for example, which are higher risk, but also potentially higher yield. The stock market has historically returned an average of 8% to 12%.

The most common investment options include:

If you’re not comfortable choosing investments or picking stocks on your own, you can always use a financial planner to make your investments for you. Many newer online brokerages even offer robo-advisers that automate the process by investing your money via algorithm.

Policygenius’ editorial content is not written by a certified financial planner or advisor. It’s intended for informational purposes only and should not be considered legal, financial, or investment advice. Consult a professional to learn what financial products are right for you.

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