In the world of IRAs -- an acronym that stands for individual retirement arrangements -- the traditional IRA (an individual retirement account) is the grand poobah of them all.
Created in 1975 by the Employee Retirement Income Security Act, the traditional IRA -- like its peers Roth, SEP, SIMPLE, and others that came later -- is a type of retirement account that holds investments of your choosing, be they stocks, mutual funds, bonds, money market funds, CDs, exchange-traded funds, and more.
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Also, like its newer IRA pals, favorable tax treatment (specifically, the ability to shield some of your money from taxes) makes it a good place to park funds you're saving for your golden years.
How a traditional IRA worksA traditional IRA is what's known as a "tax-deferred" retirement savings account; with that, you get three ways to save on taxes:
1. The money you deposit in your IRA (up to specific annual limits) is not taxed.
2. The money you contribute lowers your taxable income for the year.
3. The earnings you make on the investments as they grow within your IRA are not taxed.
Here's an example of the tax triple-play in action:
Let's say you made $30,000 during the year, and you put $5,500 of it into an IRA. That move alone earns you two of the three tax breaks. First, you don't have to pay taxes on the $5,500 IRA contribution. Then, since you've lowered your taxable income for the year by $5,500, you'll pay income tax only on $24,500 of the $30,000 you earned. (Over time, that adds up: Funnel $5,500 into a traditional IRA for 25 years, and you've shielded a total of $137,500 in income from taxation while it grows.)
The final tax advantage is that the money kept in your IRA grows free of tax through the years. That's right: You're not required to pay taxes on any dividends or gains you earn in your IRA as your investments grow.
When do you have to pay taxes?Of course, eventually you have to pay the piper. This is the "tax-deferred" part of the setup, and it happens years later when you start taking money out of the account for retirement. (You can start doing this at age 59 1/2 and avoid early withdrawal penalties.) The money will then be taxed as income at your ordinary income tax rate at the time you make withdrawals.
One important withdrawal-related note: If you withdraw funds from your traditional IRA before age 59 1/2, in most cases you'll have to pay both income tax and a 10% penalty on whatever earnings have accrued -- although there are some exceptions where the penalty can be waived.
Are you eligible for a traditional IRA?To contribute to a traditional IRA you must meet certain criteria:
- You must be under age 70 (which is also the age at which Uncle Sam requires people to start making withdrawals from their IRAs and cease making contributions).
- You have to have received taxable compensation (e.g., self-employment wages, salaries, fees, tips, bonuses, commissions, taxable alimony).
And then there's the fine print:
Contribution limits: As tempting as it might be to stash all of your long-term savings into a traditional IRA to get the tax breaks, there are limits to how much you can contribute. In 2015, the maximum contribution limit is $5,500 if you are under age 49. However, taxayers who are age 50 and over can sock away $6,500. The extra $1,000 is what's known as a "catch-up contribution" and makes turning the big 5-0 a milestone worth celebrating.
Deductibility limits: While there are no income restrictions on eligibility to contribute to a traditional IRA (as opposed to a Roth IRA), whether you qualify to receive the full benefits of a traditional IRA (all those tax breaks we just mentioned) depends on your income, your tax filing status, and what other retirement plans are available to you.
The details of that last bullet point are not as daunting as they might seem, particularly when they are spelled out with handy tables like we're about to do.
How much of your traditional IRA contribution can you deduct?Although in general terms it's a bummer to not have a workplace retirement plan (e.g., your company doesn't have a 401(k) plan or other setup that enables employees to save for retirement), when it comes to your ability to take full advantage of all that a traditional IRA has to offer, this works in your favor.
If you (being single, the head of household, or a qualifying widow(er), in terms of how you file your taxes) are not covered by a workplace retirement plan, you can deduct the full amount of your traditional IRA contributions from your taxes. Score!
And if you are married to someone in the same boat (no employer-sponsored plan to speak of), regardless of how you file your taxes (jointly or separately), you get the same deal: full deductibility of your traditional IRA contributions.
Here's a visual representation of the official IRS rules:
2015 IRA deduction Limits if you ARE NOT covered by a retirement plan at work
It gets a bit more complicated if you or your spouse does have access to workplace retirement plans. If that's the case, then your income and your tax filing status affect the amount of your traditional IRA contribution that you can deduct.
This point is best illustrated by plotting it out on a table. Find your income and filing status below to see exactly how, in technical terms, your deduction gets "phased out":
2015 IRA deduction limits if you or your spouse ARE covered by a retirement plan at work
Why bother if you can't fully deduct?It might seem like contributing to a traditional IRA isn't worthwhile if you are unable to fully deduct your contributions. However, even if you won't save on income taxes in the year you make your contribution, you're still getting the traditional IRA's benefit of tax-deferred growth within the account.
During the years your investments are growing in your IRA, you won't pay any taxes on the earnings. (Your gains aren't even reported to the IRS as income until you start taking money out years later.) And, if you're in a lower income tax bracket when you start withdrawing funds (which many retirees are), you'll take less of a tax hit than you would if your money had been in another type of account.
Keep these things in mind as you consider the best parking spot for your long-term savings.
*Modified Adjusted Gross Income (MAGI): Time for a clarifying moment. MAGI and AGI (adjusted gross income) amounts are usually pretty close -- if not identical -- to each other. Your adjusted gross income is the amount of all of the income you brought in during the year, minus certain deductions you took to lower your income (e.g., IRA contributions, alimony payments, higher education expenses, health savings account deductions, etc.). To calculate your MAGI, you add back in certain deductions. If you want to dive right in, the IRS has a worksheet to help you figure out your Modified AGI for traditional IRA purposes.
The article What Is a Traditional IRA? originally appeared on Fool.com.
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