An individual retirement account (IRA) is one way to grow wealth for your later years. IRAs come in two basic flavors—Traditional and Roth—and both come with certain tax advantages. If you’ve opted for a Traditional IRA, it pays to understand how these accounts are treated for tax purposes. Here are the most important tax rules to know.
You Can Get a Tax Break with a Traditional IRA
One of the main differences between Roth and Traditional IRAs is the way contributions are handled. Roth IRA contributions are made with after-tax dollars, while Traditional IRAs are funded with pre-tax dollars. So, what does that mean from a tax perspective?
Two things. First, you’re not paying any taxes on the money when you put it into your Traditional IRA. Your contributions can grow on a tax-deferred basis until you begin making withdrawals in retirement. More important, however, is the potential to deduct the contributions you’re making each year. Deductions reduce your taxable income, so contributing to a Traditional IRA could either help lower your tax bill or result in a bigger refund.
Whether you can deduct your full contribution each year depends on three things: your filing status, your adjusted gross income for the year and whether you (and your spouse, if you’re married) are covered by an employer’s retirement plan at work.
Let’s say, for example, that you’re single and you’re not covered by a retirement plan through your job. In that scenario, you’d be able to deduct your Traditional IRA contributions, up to the annual contribution limit, regardless of how much you make. On the other hand, if you are covered by a 401(k) or a similar plan, you’d only be able to claim the full deduction if your modified adjusted gross income (MAGI) is $63,000 or less, as of 2018. The income threshold is different for married couples who file joint or separate returns.
Getting a deduction for Traditional IRA contributions could mean paying less in taxes, but there’s yet another potential benefit. Reducing your taxable income might make you eligible for other deductions or tax credits that you may not be able to claim with a higher income.
But You Have to Pay Taxes on That IRA Eventually
A Traditional IRA offers an immediate tax benefit in the short term if your contributions are fully deductible, but you still have to pay Uncle Sam at some point. Once you begin making withdrawals from your Traditional IRA in retirement, those distributions are taxable at your ordinary income tax rate.
The same is true if you withdraw money before you retire, and in that scenario you may owe an additional tax penalty. Traditional IRAs—and Roth IRAs—allow you to begin making penalty-free distributions once you reach age 59½. If you tap into an IRA before then, you will have to pay income tax plus a 10 percent early withdrawal penalty.
There are some exceptions to this rule that allow you to avoid the penalty. Those exceptions include early withdrawals from a Traditional IRA to pay for qualified education expenses, unreimbursed medical expenses, health insurance premiums if you’re temporarily unemployed or the costs associated with buying a first home. In the case of home-buying, the IRS caps penalty-free withdrawals at $10,000.
Not Taking RMDs May Trigger a Tax Penalty
There’s another important tax consideration to be aware of with Traditional IRAs. While you can contribute to a Roth IRA indefinitely, provided you have earned income, a Traditional IRA doesn’t give you that option. Once you reach April 1 of the calendar year following the year you turn 70½, you’re required to begin taking minimum distributions from your account.
These required minimum distributions (RMDs) are based on your life expectancy and they’re non-negotiable. If you fail to take these distributions on time, you’ll pay the price in the form of a steep penalty. The penalty is set at 50 percent of the amount you were required to withdraw from your IRA. That means if your required minimum distribution was $20,000 for the year, your tax penalty would come to $10,000.
You can, of course, withdraw more than the minimum amount required. And whether you’re taking an RMD or withdrawing a little extra, the distribution is still treated as taxable income.
Traditional or Roth IRA?—Consider the Taxes
Whether to choose a Traditional or a Roth IRA is a tough question to answer, but the easiest way to think of it is in terms of the tax benefits. If you’re in a higher tax bracket now than you will be in retirement, getting a deduction on your contributions to a Traditional IRA could pack more of a punch than being able to make tax-free withdrawals from a Roth IRA. Weighing the tax pros and cons can help you decide which IRA is the best fit for your retirement savings strategy.