Traditional IRAs allow you to save for retirement, while saving on taxes today
A traditional IRA is a savings account with a valuable twist: you can deduct your eligible contributions from your income tax.
Why does that matter? Here’s an example:
You are in the 25% tax bracket this year, earn $100 dollars and then put it in a regular savings account. You’ll pay up to $25 of that money to the federal government at tax time. If you earn $10 in the first year, you’ve still actually lost money—($110 in savings – $25 in taxes = $85). It will take several years to get into positive territory.
Take that same $100 and put it in a traditional IRA and that full amount gets put to work for you right away. There are no taxes to offset your gains.
There is a wrinkle, of course: with a traditional IRA, you will pay taxes on the money when you withdraw it during your retirement years. In the best-case scenario, you’re earning less and have a lower tax rate in retirement.
IRAs that allow you to defer taxes come in many different flavors. The traditional IRA is for your “average” person, and is our primary focus. The other types of accounts—Simple IRAs, SEP-IRAs, etc.—generally apply to small business owners.
For most Americans, the main retirement savings decision is between a traditional and a Roth IRA. We explain the differences in detail HERE, but the basic idea is this: traditional IRAs let you deduct taxes now and pay them later; with a Roth, you pay income taxes now but pay no taxes when you withdraw them (Roth’s also disallow contributions at higher income levels).
Most income-earning Americans can make traditional IRA contributions until they turn 70 ½ (at which time you’re no longer eligible for a traditional IRA, whether your work or not). Once you turn 70 ½, you also must take what the government calls “required minimum distributions” from your retirement account. Simply put, you need to start withdrawing a percentage of your savings every year. The calculation can be confusing, so it’s best to consult a tax advisor or the IRS directly to determine the amount.
Most Americans can also defer taxes on their contributions, with one exception. If you or your spouse is covered by a retirement plan at work (like a 401k or 403b), and you make a significant amount of money, you may not be able to deduct your traditional IRA contributions from you current year taxes. We outline those rules here.