2021 Traditional IRA Guide – Rules, Contribution Limits, and Tax Benefits

The Traditional IRA is one of the most effective ways to invest for retirement. It offers investors incredible tax benefits now, the ability to grow your investment over time without the drag of taxes slowing down your investments, and an easy way to make withdrawals in retirement. It is not a one-size-fits-all retirement account, however. Withdrawals are taxed at the time they are made (and there may be penalties if withdrawals are made prior to age 59½). And there are also income limits to the tax deductions.

Let’s take a deep dive into the Traditional IRA and examine what it is, who is eligible, and more.

Traditional IRA – One of Many Retirement Account Options

There are dozens of ways you can invest your 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 retirement 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 employer-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 70½ and make contributions from taxable compensation (note: the HEROES Act allows deployed military members to contribute to an IRA with tax-free combat pay).

You can open a traditional IRA in a number of places such as your local bank, a brokerage company or a mutual fund company.

2021 Traditional IRA Contribution Limits

The maximum contribution limits allowed per year cannot exceed $6,000 unless you are 50 years of age or older, in which case you can contribute an additional $1,000 in catch up contributions.

Traditional IRAs share the same contribution limit as the Roth IRA, which we cover in another article. You can contribute $6,000 ($7,000 with catch-up contributions) between both accounts. This means you can contribute the full amount to a Traditional IRA or a Roth IRA, or you could contribute $3,000 to each account, or any combination that does not exceed the total annual contribution limit.

Traditional IRA Deductibility Income Limits

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. This lowers your taxable income in the current year, which is a nice benefit.

If your modified adjusted gross income (MAGI) exceeds the amount allowable by the IRS, contributions may qualify for a partial deduction. If your income exceeds the allowable MAGI, you will be ineligible to contribute to a deductible Traditional IRA (more on this in a moment).

These income limits are commonly referred to as the phaseout range and for 2020 the following limits are in place:

• $66,000-$76,000 for those filing single or head of household
• $105,000-$125,000 for married couples filing jointly

Those who earn below the lower limit can deduct the full amount from their taxes. Those whose income falls within the above ranges can deduct a partial amount of the contribution. And those whose income exceeds these limits cannot deduct any of their contributions.

The following table shows the full Traditional IRA tax deduction phase-out income ranges.

What to Do If Your Income Exceeds the Deductibility Limits?

You can still contribute to a Traditional IRA if your income exceeds the deductibility limits. However, you would need to contribute to a non-deductible IRA. Another option would be to contribute to a Roth IRA, which has different rules.

Roth IRAs are different in that the contributions are made with money that has already been taxed. The money then grows in your Roth IRA account and is not taxed at withdrawal, provided you meet the withdrawal requirements (there is a 5-year rule and a 59½ minimum age requirement).

Roth IRAs also have income limits, which need to be considered before deciding to contribute to a Roth instead of a Traditional IRA.

If you exceed both the Deductible Traditional IRA and the Roth IRA income limits, then consider contributing to a non-deductible Traditional IRA. This still allows you to contribute to an IRA, even though you don’t get the tax deduction when you file your return.

There are some advanced tactics you can do with these contributions, however, such as converting them to a Roth IRA at a later date. I recommend reading up on this, as it is a more advanced topic and may cause a taxable event. You can consult with a tax professional or a fee-only financial planner for more information.

There are pros and cons to both Traditional and Roth IRAs. So I recommend comparing them to determine which is better for your situation.

Benefits of Using a Traditional IRA

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 (when you make withdrawals from your investments).

If distributions are made from a traditional IRA before the account owner is 59½ 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 72 at which time Required Minimum Distributions (RMDs) must begin.  Failure to take the required mandatory distributions will result in a 50% penalty of the required withdrawal amount 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 income 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:

• Comparing Traditional and Roth IRAs.
• Why Military Members Should Open Roth IRAs.
• IRS Publication 590, Individual Retirement Arrangements (IRAs).