There are dozens of ways you can invest our money, but that doesn’t mean you need to let it become confusing. Each investment opportunity has unique benefits, and the first step is to define your investment goals. When looking at retirement investing, it’s best to focus on those types of investments that offer tax benefits. These usually fall into two main categories – employer sponsored retirement plans, such as a 401k or the Thrift Savings Plan, and individual plans, such as an IRA.
For many investors, an individual retirement arrangement (IRA) is the ideal way to save toward retirement and earn the most from your investments. An IRA can be used alone or in conjunction with other retirement accounts. Within the world of IRAs there are several options from which to choose, including the Roth IRA and several IRAs designed for self-employed individuals, and those working for small companies. Here we look specifically at the traditional IRA and who benefits most from this type of savings account.
What is a traditional IRA?
A traditional IRA is a savings plan which allows contributors to use pre-tax dollars to invest in stocks, bonds, CDs, mutual funds and other investment vehicles. The traditional IRA is a popular savings tool for individuals who may not have access to employee sponsored retirement plans or for those who want to have an additional retirement account which offers tax-deferred growth on investments.
How does the traditional IRA work?
To open a traditional IRA you must be under the age of 70 1/2 and make contributions from taxable compensation (note: the HEROES Act allows deployed military members to contribute to an IRA with tax free combat pay).
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Contribution Limits. The maximum contribution limits allowed per year cannot exceed $5,000 unless you are 50 years of age or older in which case you can contribute an additional $1,000 in catch up contributions.
Owners of a traditional IRA may use their contributions as a tax deduction when filing their income tax as long as they fall within income thresholds set forth by the IRS. If your modified adjusted gross income exceeds the amount allowable by the IRS contributions may qualify for a partial deduction. These income limits are commonly referred to as the phaseout range and for 2010 the following limits are in place:
- $55,000-$66,000 for those filing single or head of household
- $89,000-$109,000 for married couples filing jointly
When contributions qualify as a tax deduction, owners of a traditional IRA can benefit by lowering their taxable income when they file their federal tax return. This allows for tax-deferred growth on contributions and earnings throughout the lifetime of the IRA. It is important to note that distributions from a traditional IRA are subject to taxation at the time of distribution. If distributions are made from a traditional IRA before the account owner is 59 1/2 years of age, they will be subject to a 10% early withdrawal penalty as well. Contributions to a traditional IRA must cease when the account owner reaches age 70 1/2 at which time minimum mandatory contributions must begin. Failure to take the required mandatory distributions will result in a 50% penalty from the IRS.
Is a traditional IRA a good investment?
The traditional IRA can be a great investment vehicle for individuals who understand the rules and fall within eligibility requirements. For many, the immediate tax benefits associated with the traditional IRA make this type of account very attractive. If you anticipate being in a lower tax bracket at the time of distribution, the traditional IRA may be the right account for you. As with any other investment strategy, it is important to understand the benefits as well as drawbacks to make the best decision regarding your retirement savings.
For more information about IRAs, see:
- Roth IRA Rules.
- Comparing Traditional and Roth IRAs.
- Why Military Members Should Open Roth IRAs.
- IRS Publication 590, Individual Retirement Arrangements (IRAs).