Individual retirement account funded with pre-tax dollars
What is a Traditional IRA?
A Traditional IRA is a tax-advantaged investment account available to individual taxpayers. This type of investment account allows investors to “shelter” a portion of their income from current taxes, pay those taxes later, and hopefully enjoy larger investment gains.
The idea behind the government-created tax sheltering vehicle is to encourage greater financial independence and stability among American retirees, i.e. not to rely solely on a company pension, 401k, or social security.
The two key attributes of traditional IRAs are that contributions are tax-deferred meaning taxes are paid later and that there is no income limit to being able to contribute to a traditional IRA as there is with a Roth IRA.
If you expect your tax rate to be lower during retirement than it is today a traditional IRA may allow you to capture tax savings.
- With traditional IRAs taxes are deferred allowing your investments to grow tax-free until withdrawal.
- Traditional IRAs come with required minimum distributions forcing you to withdrawal money in retirement even if you don’t need to.
- Withdrawing money from a traditional IRA before retirement results in penalties.
Traditional IRA Traits and How they Work
Traditional IRAs are individual retirement accounts aimed at helping people grow their wealth. Like any retirement account, they have their own traits that draw people to them. Here are the 6 defining traits of Traditional IRAs.
1. Taxes on income contributed to traditional IRAs are tax-deferred
Why pay taxes now when you could pay them later? This general concept will be a defining factor in determining if a traditional IRA is right for you or not.
If your taxes are currently high, it might be advantageous to grab a tax break on some of your income and pay taxes on it later if your tax rate is likely to go down. Most likely, this will be a concern more for people further into their career then those just starting out.
2. Traditional IRAs cannot be held indefinitely because of required minimum distributions
Since the government is passing on tax revenue today they will want to get it later. For traditional IRAs, this shows up in required minimum distributions (RMDs). Essentially the government forces you to withdrawal portions out of your traditional IRA in retirement so they can recoup their foregone income tax.
3. Traditional IRAs are an investment account, not an actual investment themselves
Traditional IRAs are similar to a normal brokerage account (minus the tax benefits) in that their just an account. This means you can invest money in individual stocks, mutual funds, ETFs, bonds, or other investments. Likely, the best returns on investment for a long-term account like this will be with stocks, ETFs, and mutual funds.
4. There is no income limit to being able to contribute to a traditional IRA
Unlike with other tax-advantaged retirement accounts, traditional IRAs do not have a maximum income level that prohibits you from being able to use a traditional IRA. That said, the tax-deferral benefit that initially comes with a traditional IRA goes away for high-income individuals.
5. Often used as a backdoor method for Roth IRAs
The brother to a traditional IRA is a Roth IRA which comes with income limits that prohibit individuals from contributing to them. The way to get around this is to make your contribution to a traditional IRA then convert the traditional IRA to a Roth IRA since converting IRAs is allowed regardless of income.
6. Early Withdrawals come with significant penalties
There’s a reason it’s called a retirement account – it’s for retirement. Since the government is passing on a tax shelter to help people establish their retirement the government wants to discourage early withdrawals outside of retirement.
The way this works with a traditional IRA is that early withdrawals are penalized with having to pay the income tax and potentially a 10% penalty.
Math Behind a Traditional IRA vs No Tax-Advantaged Account
So how does the math work out with a Traditional IRA? What impact does the tax advantage make? The short answer is, pretty significant. To make this point we can look at an example comparison between an IRA and a traditional brokerage account without tax benefits.
Traditional IRA
Let’s say we’re less than 25 years old and in the 24% tax bracket. In our scenario, we’re all about opening and contributing to a Traditional IRA. In our first year of owning our Traditional IRA, we decide to dedicate $6,000 of our income to the account.
To keep it simple, let’s say this is the only contribution we ever make to our Traditional IRA, here’s how the math would work out.
Since we’re contributing $6,000 to a traditional IRA we won’t pay income taxes on this, that’s a savings of $1,440 right now. If we allow our investment to grow for say 40 years (puts us in retirement) and we invest in stocks/mutual funds returning a realistic 10% average our Traditional IRA would end up being worth ~$271,555.
With our investments in a Traditional IRA, the $271,555 value of our account is not free from income taxes so when we make withdraws from the account, we will need to pay income taxes. If we have dropped tax brackets then we will have a tax saving. Still, we are free from capital gains tax on our $271,555.
Not too bad but how does this compare to a normal, not tax-advantaged brokerage account?
*This example is extremely simplified to illustrate the concept. For example, taxes are graduated meaning your effective income tax is likely going to be lower than 24% if you’re in that tax bracket.
Normal Brokerage Account
If we keep all the conditions from the scenario above but change our account type to a normal brokerage account -no tax advantages attached- how would the math change?
In the case we use a normal brokerage account dedicating $6,000 of our income towards the investment account, we would have to pay taxes upfront and only have $4,560* to invest after we pay taxes. If we were to invest in the same stocks/mutual funds we did above and earned the same realistic 10% annual average for 40 years our account would grow to ~$206,382.
While on the surface our IRA looks larger but if we are still in the 24% tax bracket then we are essentially equivalent to the ~$206,382 from a normal brokerage account.
So how is this any different? Since, in this scenario, we’re using a normal brokerage account we still have to pay capital gains on our investment gains. Subtracting our initial investment from our ending investment our gain is ~$201,822. This is the amount we will likely have to pay capital gains tax, most likely 15%. Applying the tax, we end up receiving $181,640 and pay the government $20,182 from our account.
*This example is extremely simplified to illustrate the concept. In addition to the tax consideration from above, we omitted the effect of capital gains on trading costs for portfolio repositioning.
Conclusion
In either case, when keeping everything equal, you would have saved a meaningful amount towards your retirement.
So, which is better? Generally, an IRA with a Roth being best for younger people, however, it depends. What really decides which is better is answering “do I need this money and its possible gains before retirement?”, “are there investments I want to make that cannot be made within an IRA?”, “Are there better investments that cannot be made within an IRA?”
Backdoor Roth IRA
With the popularity of Roth IRAs since they do not come with a required minimum distribution, many people who earn too much to directly contribute to a Roth use the backdoor approach. Since the government allows people using Traditional IRAs to convert them to Roth IRAs and there is no income limit to contribute to a Traditional IRA, people who earn too much for a Roth can deposit money into a Traditional IRA then convert the IRA to a Roth IRA. Here are the steps:
- Money is put into a traditional IRA – new or existing
- Traditional IRA is then converted to a Roth IRA – requires some paperwork
- Taxes are paid – since Roth’s are for after-tax dollars you must pay tax on any money that hasn’t been taxed yet.
Eligibility and Limits
We have included a detailed table of the contribution and deduction limits for Traditional IRAs below:
Traditional IRA Deduction Limits 2021
| Filing Status | 2021 Income (MAGI) | Deduction |
|---|---|---|
| Single/Head of Household | $66,000 or less | 100% Deduction of Contribution |
| Single/Head of Household | $66,000 to $76,000 | Deduction Phaseout / Partial |
| Single/Head of Household | Above $76,000 | No Deduction |
| Married Filing Jointly | $104,000 or less | 100% Deduction of Contribution |
| Married Filing Jointly | $104,000 to $125,000 | Deduction Phaseout / Partial |
| Married Filing Jointly | Above $125,000 | No Deduction |
Benefits and Drawbacks of Traditional IRAs
Traditional IRA Benefits
- Taxes are differed to the future
- No income limits to contribute to a traditional IRA
- May reduce the tax bill and tax bracket
- Future gains are not subject to capital gains tax
- Investment account is open to almost any investment
- Money is not easily withdrawn
Traditional IRA Drawbacks
- Taxes must be paid later leaving the investor open to income tax increase risk
- Comes with a required minimum distribution meaning these funds typically cannot be held late into life.
- Money is not easily withdrawn
- Limited contribution amount
- Some investments cannot be used within IRA
Helpful Links
Calculate Required Minimum Distribution
Current Deduction and Contribution Limits
*Lottie animation is from lottiefiles.com and was created by KC Woon