One of the most fundamental tools available to you for Planning for the future is the Traditional IRA. It has been a cornerstone of retirement planning for decades, yet many people still find the mechanics a bit fuzzy.
Let’s clear up the confusion and look at exactly how this account works so you can decide if it belongs in your financial toolkit.
The Tax Break You Get Now, Not Later
We all want to keep more of our hard earned money when tax season arrives. This is where many new investors start asking what is a traditional IRA regarding their overall financial strategy. It is a personal savings plan that gives you tax advantages for setting money aside for retirement.
You can usually deduct your contributions from your taxable income for the year. This lowers your tax bill right now. While you might choose a modern financial platform like SoFi to host your account, the internal revenue service sets the universal contribution rules.
The money you contribute grows without being taxed until you withdraw it. This allows your savings to compound faster because taxes do not eat away at your gains every year. You delay the tax bill until you are retired and likely in a lower tax bracket.
The Rules for Putting Money In
While saving is great, the IRS puts a cap on how much you can stash away annually. You cannot just dump your entire salary into the account. There are annual contribution limits that change periodically based on inflation. Also, you generally need to have earned income to contribute.
If you are not working, you usually cannot open one, although there is a “spousal IRA” exception for non-working spouses who file jointly.
The Penalty for Taking Money out Too Early
Retirement accounts are designed for the long haul, and the government enforces this with strict rules. If you try to access your funds before age 59½, you will likely face a 10% penalty on top of the income taxes you owe.
It acts as a heavy deterrent to keep you from raiding your nest egg for non-essentials. There are exceptions for things like first-time home purchases or qualified education expenses, but generally, this money is locked up tight until you are older.
What Happens at Retirement Age
Once you cross that 59½ threshold, the penalty disappears. You can start taking distributions, and since you didn’t pay taxes on this money when you put it in, you pay them now. The money is taxed as ordinary income.
Later, usually around age 73, you will encounter Required Minimum Distributions (RMDs). The government won’t let you defer taxes forever, so they eventually force you to start withdrawing a specific amount each year whether you need the cash or not.
How an IRA Fits With Your 401(k)
You don’t have to choose between a workplace plan and an individual one; they can often work together. Many people contribute to a 401(k) to get their employer match, which is essentially free money, and then open a Traditional IRA to access a wider range of investment options.
However, if you have a retirement plan at work, your ability to deduct your Traditional IRA contributions might be reduced depending on your income level. It is important to check the current IRS deduction limits if you are covered by a workplace plan.
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