The traditional IRA does not have quite the illustrious history of the Roth IRA (see my article on Roth IRAs here) however, it does have a much longer one. The traditional IRA was created in 1974 with the passage of the Employee Retirement Income Security Act (ERISA). Many IRA plan types, including the Roth, have evolved from that landmark bill.
After reading my article about Roth IRAs, let’s take a look at a similar Roth example, but with a traditional IRA, which will help you understand the differences.
In early 2015, you contribute $5,500 into a Traditional IRA account. In late 2020 you are age 59 ½ and decide to buy a boat. That $5,500 has grown to $10,000. You withdraw the $10,000, buy your boat, and pay taxes on your withdrawal. You then toast Uncle Sam from the helm of your new boat and happily sail away.
Now let’s get a little more granular on each piece of the example:
- Contribution amount: In 2016, the traditional IRA contribution limits are $5,500 if you are age 49 and below or $6,500 if you are age 50 or older thanks to a catch-up provision (exact same as a Roth). Remember from my previous article, you must have earned income of at least the amount you are contributing. Another key aspect of this contribution amount is whether it is with pre-tax or post-tax money. We spelled out that a Roth IRA is always with post-tax money; however, a traditional IRA can be with either pre- or post-tax money, depending on income limitations and whether your company offers a qualified retirement plan. In the example above, the contribution is to a deductible traditional IRA and therefore you get a tax deduction at the time you contribute and none when you withdraw.
- Time period (e.g. 2015-2020): A traditional IRA has no rule on how long the money must be in the account before you can withdrawal it penalty-free (e.g. the 5-year rule with Roth IRAs). However, for a traditional IRA account, you cannot withdrawal any earnings, unless for qualified reasons (exceptions to tax on early distributions), until you are age 59 ½ if you want to avoid the 10% early withdrawal penalty.
- Age 59 ½: This age is a common denominator among IRA accounts because once you reach 59 ½, you can take penalty free qualified distributions from your account.
- Withdrawals: When you take withdrawals from a traditional IRA for qualified purposes, the distribution is considered a taxable event and you are taxed on the entire amount you withdrew. In the above example, John took the full amount out so the full $10,000 was taxed.
- Taxes: A traditional IRA is tax deferred, which means you can make trades within the account, accumulate gains over time, and pay no income taxes on those realized gains until you are over 59 ½ or wait until you are required to take distributions at age 70 ½. Ordinary income taxes will be paid on all monies when withdrawn from the account. The tax deferred distribution of gains makes the Traditional IRA an attractive investment option for many people. IRA Deduction Limits differ if you are covered by an employer plan or not.
HCM has the tools and knowledge to help you sort through any questions you may have around a Traditional IRA, including helping you establish one of these plans. If you want to walk through this together, feel free to reach out to me at firstname.lastname@example.org.
Date Posted: 03/31/2016 Advice provided in this article is meant for educational purposes only and financial education is important to us. Before making decisions regarding your personal financial situation, please consult an advisor or conduct your own due diligence. If you would like to discuss your Wealth Accumulation or Retirement Income Plan with an HCM Wealth Advisor, please give us a call – 513-598-5120. Located in Cincinnati, Ohio, we serve clients in 23 states, and we’d love to help.