Individual Retirement Accounts (IRA) 101
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Traditional IRAs offer eligible savers thousands in tax deductions, but the bigger benefit is the way they allow you to invest for the future.
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Understanding traditional IRAs
A traditional IRA is an individual retirement account that offers tax advantages to savers. (It’s called a “traditional” IRA to distinguish it from a Roth IRA — more on those below.)
Here are the key details on the traditional IRA:
The IRA contribution limit is $5,500, or $6,500 if you’re 50 or older, for 2018, and you can use it to save even if you already participate in a workplace retirement plan, such as a 401(k).
When the saver is eligible, traditional IRA contributions are deducted in the year they are made.
Investments grow tax-deferred within this type of IRA, meaning you won’t be taxed on gains until you withdraw them.
Retirement distributions are taxed as ordinary income.
Unless they meet certain conditions, early withdrawals may be taxed as income and assessed a 10% penalty.
Because of the upfront tax deduction, traditional IRAs are especially attractive if you’re looking to reduce the sting of your tax bill today. This might be true if you are in your peak earning years and paying a high marginal tax rate. If you expect your tax rate will go down in retirement, you stand a decent chance of minimizing your overall tax burden by choosing a traditional IRA.
The alternative tax strategy comes in the form of a Roth IRA, the traditional IRA’s cousin. These accounts reverse the tax benefit of a traditional IRA: There’s no tax deduction when you make contributions, but distributions of both contributions and earnings come out tax-free in retirement.
For more, read our Roth IRA versus traditional IRA comparison.
What are the benefits of a traditional IRA?
These accounts have far more benefits than drawbacks. Still, it’s important to note the strengths and weaknesses when comparing traditional IRAs with other retirement savings vehicles:
Are you eligible for a traditional IRA?
The good news: Everyone is technically eligible for a traditional IRA. The bad news: Not everyone is eligible to deduct their contributions to a traditional IRA. It boils down to whether you or your spouse is covered by an employer retirement plan, like a 401(k), and your income.
The IRS doesn’t want you to squeeze too much out of the system, so if you or your spouse also has a retirement plan at work, the amount of your traditional IRA contribution that you can deduct is reduced, then eliminated altogether, once you hit a certain income. To be clear, you can still make contributions, but they won’t be tax-deductible. See the table below for details.
Should you contribute if you can’t deduct?
Nondeductible IRA contributions can still be valuable: Money saved for retirement is money saved for retirement, and this money will still generate investment growth tax-deferred. But this can also be a headache: You are responsible for keeping track of after-tax contributions by filing IRS Form 8606 each year so you’re not taxed again on that money when you take retirement distributions.
In short, there are better options you should max out before going down the nondeductible IRA road. They are:
A Roth IRA, if you’re eligible. These accounts have income eligibility rules, but they are higher than the limits to deduct traditional IRA contributions. See our IRA limits page for the 2018 guidelines on both account types.
Your employer-sponsored retirement plan. You should max that out before making nondeductible IRA contributions. Doing so may actually enable you to be eligible for an IRA deduction because your contributions to the workplace plan lower your taxable income for the year.
If after exhausting both of those options, you still want to consider the nondeductible route, see our page on nondeductible IRAs.
Where can you open a traditional IRA?
Many financial services companies offer traditional IRAs, including online brokers and robo-advisors.
If you are interested in selecting your own investments for your IRA, an online broker is likely a good home for your account. With a broker, you’ll select from investments accessible through that provider, including stocks, bonds and mutual funds. (Remember, a traditional IRA isn’t an investment itself, but an account that holds investments.)
Here are some of NerdWallet’s top broker picks for IRAs:
If choosing your own investments sounds too daunting, consider a robo-advisor. These providers, which now include many of the most recognizable names in investing, use automated technology to choose investments based on your goals and investing horizon, all for a fraction of what a traditional investment manager might charge.
Here are some of NerdWallet’s top picks for IRA robo-advisors:
» Want to review more IRA providers? See our full roundup of the the best IRA providers.