How traditional IRAs work

Save for retirement while saving on your taxes, whether or not you have a work-sponsored plan.

Elissa

Elissa Suh

Published January 3, 2020

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KEY TAKEAWAYS

  • An IRA lets you save for retirement without going through an employer, and it can lower your annual taxes

  • A traditional IRA works similarly to a 401(k): you and only pay income tax as you withdraw money in retirement

  • The 2020 contribution limit for a traditional IRA is $6,000, plus another $1,000 if you’re 50 or older

  • You may be able to deduct your traditional IRA contributions on your taxes, depending on your income

An IRA, or individual retirement account, allows you to save for retirement without having to go through an employer. There are multiple types of IRAs, but they all let you invest for retirement while also helping you save on your taxes. You can still contribute to an IRA if you already contribute to an employer’s retirement plan, such as a 401(k).

A traditional IRA is the most common type of IRA and it’s what most people are referring to when they talk about an IRA. A traditional IRA allows you to save for retirement while deferring taxes until you withdraw the money in retirement. You don’t pay any taxes as your money grows in the account and if you contribute money that was already taxed, you can get a tax deduction on your annual tax return.

Money you withdraw from your traditional IRA is taxed as regular income but since most people are in a lower tax bracket later in life than during their working years, they end up saving on income taxes in the long run.

In 2020, the maximum contribution for a traditional IRA is $6,000. You can contribute an additional $1,000 as a catch-up contribution if you’re age 50 or older. (The contribution limits were the same in 2019.)

How a traditional IRA works

A traditional IRA allows you to invest for retirement while avoiding income taxes until you withdraw money from the account. You can qualify for a tax deduction if you contribute money that was already taxed, though the deduction phases out at higher incomes. Any investments you make within a traditional IRA will grow tax-free (normally you have to pay capital gains tax on investment gains).

Once you reach age 59½, you can begin to make penalty-free withdrawals of the IRA funds. A withdrawal from a retirement account is known as a distribution. Withdrawals before age 59½ are usually subject to an early-withdrawal penalty worth 10% of the amount you withdraw, plus you have to pay income tax that year on the money you withdrew.

You also have to take distributions, called required minimum distributions (RMDs), once you reach a certain age: 70½ if your 70th birthday was before July 1, 2019; 72 if your 70th birthday is July 1, 2019 or later. The value of your RMDs is based on your age and the balance of your account. Use this IRS worksheet to calculate your RMDs.

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Who qualifies for a traditional IRA?

You can open a traditional IRA as long as you have some taxable earned income. There are no other income limits. In the eyes of the IRS, earned income is basically any money you earn in exchange for doing work. Examples of unearned income include rent payments, investment income, Social Security benefits, and unemployment benefits. If you have unearned income you can still open an IRA as long as you t also have some earned income.

Exceptions to the IRA early withdrawal penalty

According to the IRS, you can withdraw money from a traditional IRA before age 59½ without paying the 10% penalty if you meet one of the following:

  • You use your IRA distributions to buy, build, or rebuild a first home.
  • You took the distribution as a qualified military reservist (see IRS publication 590b for more detail).
  • You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income. (You may also qualify for the medical expense deduction.)
  • Your distributions are less than or equal to your qualified higher education expenses.
  • Your distributions are less than or equal to the cost of your medical insurance due to unemployment (such as COBRA coverage).
  • You receive the distributions in the form of an annuity.
  • You are the beneficiary of an IRA. (You can usually withdraw without penalty from an IRA you inherit.)
  • You took the distribution as part of the IRS seizing your account (through an IRS levy).
  • You meet the government’s definition of totally and permanently disabled.

Traditional IRA contribution limits for 2020

For 2020, here are the traditional IRA contribution limits:

  • If you’re under 50, your total IRA contribution limit is $6,000.
  • If you’re age 50 or older, you can contribute up to $7,000 (the standard $6,000 plus a $1,000 catch-up contribution).

Your contribution amount can only be as much as your earned income, though. So if your earned income for the year was $5,000, then you can only contribute up to $5,000 that year. The annual IRA contribution limit also applies across all types of IRAs. For example, if you already contributed $5,000 to a Roth IRA this year, then the maximum you can put in a traditional IRA is $1,000.

You also have until Tax Day to make your IRA contributions. That means for 2019, you can still fund your IRAs through July 15, 2020. The deadline is usually April 15, but Tax Day was moved because of the coronavirus.

The IRA tax deduction

Traditional IRAs are usually funded with after-tax income, meaning you already paid income tax, but you can recoup money through the IRA deduction.

The IRA deduction allows you to potentially deduct your entire traditional IRA contribution for that tax year. For example, if you earned $50,000 this year and contributed $6,000 to your traditional IRA, you can claim a deduction of $6,000 on your tax return and you only have to pay taxes on the remaining $44,000 of your income. The amount you can deduct phases out at higher income levels, based on your tax filing status. It also phases out more quickly if you’re covered by a retirement plan at work.

The income used to determine your eligibility for the deduction is your modified adjusted gross income (MAGI), which is your total annual income minus the value of certain expenses you incurred.

On official IRS forms, you will likely see the terms full deduction and partial. The full deduction is worth the same as your traditional IRA contribution, up to $6,000. A partial deduction would be worth only part of your contribution.

Related article: 50 tax credits and deductions to consider in 2020

IRA tax deduction if you have a workplace plan

If you have access to a retirement plan through your employer, the maximum value of your IRA deduction begins to phase out for people of all filing statuses, but at different income levels.

For single filers and heads of household, you can claim a full deduction if your MAGI is $65,000 or less in 2020. You can claim a partial deduction if your income is more than $65,000 but less than $75,000. You do not qualify for any deduction with income over $75,000.

Filing Status: single filer

DEDUCTIONMODIFIED AGI in 2019MODIFIED AGI in 2020
Full$64,000 or less$65,000 or less
PartialBetween $64,000 and $74,000Between $65,000 and $75,000
None$74,000 or more$75,000 or more

Joint filers and qualified widow(er)s can claim a full IRA deduction in 2020 with an MAGI of $104,000 or less. A partial deduction is available for incomes between $104,000 and $124,000. You won’t receive any deduction if your income is $124,000 or more.

Filing status: married filing jointly or qualifying widow(er)

DeductionModified AGI in 2019Modified AGI in 2020
FullLess than $103,000Less than $104,000
PartialBetween $103,000 and $123,000Between $104,000 and $124,000
None$123,000 or more$124,000 or more

People who are married but file separately can’t receive a full IRA deduction, and they can only receive a partial deduction if their MAGI is less than $10,000.

Filing status: married filing separately

DeductionModified AGI in 2019Modified AGI in 2020
PartialLess than $10,000Less than $10,000
None$10,000 or more$10,000 or more

IRA tax deduction if you don’t have a workplace plan

If you don’t have access to a retirement plan at work, you can receive the IRA tax deduction if your filing status is single, head of household, or qualifying widow(er). Joint filers can also receive the full deduction if at least one spouse doesn’t have a workplace retirement plan.

If you're married and filing jointly, but one spouse has a workplace plan, you can claim a full IRA deduction in 2020 with income of $196,000 or less. A partial deduction is available for incomes between $196,000 and $206,000.

Filing status: married filing jointly with one spouse covered

DeductionModified AGI in 2019Modified AGI in 2020
FullLess than $193,000Less than $196,000
PartialBetween $193,000 and $203,000Between $196,000 and $206,000
None$203,000 or more$206,000 or more

Taxpayers who are married filing separately for 2020, and have a spouse who contributes to a workplace plan, can only receive a partial deduction and need income of less than $10,000.

Filing status: married filing separately with one spouse covered

Modified AGI in 2019 or 2020Deduction
Less than $10,000Partial
$10,000 or moreNone

Traditional IRA vs 401(k)

A traditional IRA works similarly to a 401(k). The biggest differences are that maximum contributions are lower for IRAs and employers don’t often manage or contribute to someone’s IRA. You can contribute to both a 401(k) and an IRA, which some people do in order to maximize their retirement savings. (Learn more about how much retirement costs in your area.)

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
Contribution limit for 2020$6,000 (also for 2019)$19,500 ($19,000 for 2019)
How you contributeAfter-tax dollars, but with a tax deductionPre-tax dollars
How your money growsTax-deferredTax-deferred
Investment optionsFlexibleLimited by plan
Penalty-free withdrawalsBegin at age 59½Begin at age 59½
Required minimum distributions (RMDs)Begin at age 70½ or 72Begin at age 70½ or 72

Traditional IRA vs Roth IRA

The biggest difference between traditional IRAs and Roth IRAs is when you pay income tax. Roth IRAs are funded by after-tax contributions, your money grows tax-free in the account, and you do not have to pay any income taxes when you withdraw the money.

Roth IRAs do not have RMDs and you can even withdraw your contributions before age 59½. You will still pay a 10% penalty if you withdraw any of your gains before age 59½ and before you’ve had the account for at least five years.

A Roth IRA can benefit you if you’re in a higher tax bracket when you retire than when you contribute money. In that situation, you would save on your taxes in the long-term. Some examples of people who may benefit from a Roth IRA instead of a traditional IRA are recent college graduates and people who are early in their careers.

If you’re self-employed or work for a small business, you may also want to consider other types of IRA, like a SIMPLE IRA or SEP IRA.

Where to open a traditional IRA

You can open a Roth IRA at many banks and credit unions, at an asset-management company, or through an online brokerage.

Common IRA providers are:

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

Regardless of where you open an IRA, it’s important to understand what your investments options are and how hands on you want to be with managing your account. In general, your IRA provider (also called a custodian) should give access to at least exchange-traded funds (ETFs) or mutual funds. These can be good options for people who mostly want a set-it-and-forget approach to investing. You may also want to consider a robo-advisor.

Someone who wants more control over their money may want to look for a provider offering stocks, bonds, and certificates of deposit (CDs). A different type of IRA may also give you more control over your investments, like with a self-directed IRA.

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About the author

Personal Finance Editor

Elissa Suh

Personal Finance Editor

Elissa is a personal finance editor at Policygenius in New York City. She writes about estate planning, mortgages, and occasionally health insurance. In the past she has written about film and music.

Policygenius’ editorial content is not written by an insurance agent. It’s intended for informational purposes and should not be considered legal or financial advice. Consult a professional to learn what financial products are right for you.

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