Traditional IRAs: Get Tax-Deferred Retirement Savings

A young, smiling woman works on a traditional IRA on her laptop in her kitchen.

(Image credit: Getty Images)

last updated 4 November 2024

When it comes to retirement planning, the traditional IRA is a workhorse, enabling you to sock away earned income. According to a report from the U.S. Bureau of Labor Statistics in 2022, about 31% of private industry workers did not have access to employer-provided retirement plans like 401(k)s. The traditional IRA (Individual Retirement Account) can help fill that gap. A traditional IRA provides valuable tax benefits, such as the deduction of contributions and the deferral of taxes on the earnings in the account.

“With the increasing number of individuals taking on side jobs, starting new businesses, or working as an independent contractor, the ability to open an IRA to save for retirement is key,” said Jennifer Kohlbacher, who is the director of wealth strategy at Mariner.

However, traditional IRAs are subject to many rules, and violations can result in costly penalties. So, let's examine what you need to know.

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Traditional IRA basics

There are contribution limits. For 2024 and 2025, you can contribute up to $7,000 to a traditional IRA. But when you reach 50 or over, you can make a “catch-up” contribution of $1,000.

All contributions must be from earned income. This includes wages, commissions, tips, bonuses and net earnings from self-employment income. However, many income sources do not count, such as interest, capital gains, rental income, dividends, pensions, unemployment compensation and annuities.

Contributions can lower your next tax bill. Let’s take an example of how a traditional IRA works. Suppose you are 53 and married, with earned income of $80,000. You can contribute up to $8,000, which includes the $7,000 maximum plus the $1,000 catch-up contribution. You have until the tax filing deadline of the following year — typically April 15th — to make these contributions for the current tax year.

Your spouse, who is 48, does not have earned income. But they can have an IRA too. This is known as a spousal IRA. You can tap your own earned income to make the contribution. In other words, you can make combined contributions of $15,000, and they are deductible. This means that your taxable income is $65,000 ($80,000 minus $15,000) and the tax savings are $3,300 ($15,000 multiplied by 22%).

You have investment choices. With these contributions, you can invest your IRA in stocks, bonds, mutual funds and ETFs. Some IRAs, called Self-Directed IRAs, even allow investments in cryptocurrencies and real estate. But there are some restrictions, such as collectibles.

Earnings from these investments are tax-free — that is, until you make withdrawals. So if you have $500 in capital gains and dividends, you would have an additional $110 in tax savings.

Withdrawals

You can withdraw funds from your IRA at any time. But if you do this before reaching 59 ½, you will be subject to paying a 10% penalty and income taxes on the amount.

The IRS does provide exceptions to the 10% penalty, though not on taxes due, in the following cases:

Total and permanent disability
Health insurance premiums while unemployed
Unreimbursed medical expenses
Expenses for higher education for you, your child and even your grandchild
First-time home purchases up to $10,000
Losses incurred due to federally declared disasters
Substantially Equal Periodic Payments (SEPPs), sometimes used by those hoping to retire early

While it may be tempting to take a penalty-free withdrawal, retirement planning experts discourage their clients from making early withdrawals.

“This can create a ripple effect with significant financial repercussions,” said Gerard Longo, who is the director of retirement plans for Global Wealth Advisors. “An early withdrawal means these funds will no longer benefit from tax-deferred growth. Early distributions can also disrupt your long-term financial planning and may result in a smaller nest egg when you retire. Less money saved for retirement may also hasten the depletion of other savings and even borrowing in retirement. Making an early withdrawal may even push you into a higher tax bracket.”

Drawbacks

While a traditional IRA can be a great way to boost retirement savings, it has some drawbacks.

First, there may be negative tax consequences if you or your spouse are covered by an employer plan. In this case, you can still contribute to an IRA, but the deduction based on your income is phased out.

Another disadvantage is that you are subject to required minimum distributions (RMDs). Based on legal requirements, you must start withdrawing from your IRA when you reach age 72 or 73. Not doing this will result in a 25% penalty.

Finally, the tax benefits of an IRA will be diminished if you are in a higher tax bracket when you retire. So, if tax rates are higher or you have more income during your retirement, you could ultimately have a larger tax burden.

The alternative: Roth IRAs

You might want to consider a Roth IRA if you suspect you'll be in a higher tax bracket during retirement than in your working years. That's because Roth IRAs do not provide tax deductions for contributions, but rather, the withdrawals are generally tax-free so long as you meet certain requirements.

And there are other benefits. “Roth IRAs do not mandate RMDs during the account holder's lifetime, allowing the funds to continue growing tax-free for as long as the account remains open,” said Julio Bedolla, a wealth manager at LourdMurray. “Another advantage of Roth IRAs is their effectiveness as tools for estate planning. Heirs can inherit the account and continue to benefit from its tax-free growth. While recent changes have limited the time period for which these benefits can be extended, Roth IRAs remain valuable in planning for the next generation.”

There are contribution limits and income requirements for Roth IRAs, so do your homework before you decide between a Roth IRA or a traditional IRA.

Tom Taulli has been developing software since the 1980s when he was in high school. He sold his applications to a variety of publications. In college, he started his first company, which focused on the development of e-learning systems. He would go on to create other companies as well, including Hypermart.net that was sold to InfoSpace in 1996. Along the way, Tom has written columns for online publications such as Bloomberg, Forbes, Barron's and Kiplinger. He has also written a variety of books, including Artificial Intelligence Basics: A Non-Technical Introduction. He can be reached on Twitter at @ttaulli.