Make the most of your traditional IRA

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Generally, investors have two options for their individual retirement accounts (IRAs). The first option is a traditional IRA, and the second option is a Roth IRA (named for the account's congressional sponsor), which features — among other benefits — the ability to receive tax-free earnings under certain circumstances. In this article, we'll discuss the features of the traditional IRA. You may want to review material outlining the Roth IRA — or talk to a financial professional — before you make a decision as to which IRA may be right for you.

What is a traditional IRA?

A traditional IRA allows any investment earnings to grow tax deferred until withdrawn, typically at retirement. Generally, if you have earned income or receive alimony, you can establish as many IRAs as you want prior to the tax year in which you reach age 70½. You may also have an IRA even if you participate in a qualified pension, profit sharing, or other retirement plan. Your entire contribution may not be deductible on your income tax return, depending on your income and whether you (or your spouse) participate in an employer-sponsored retirement plan.
Traditional IRAs offer two distinct advantages in terms of taxes: potential deductibility of contributions and tax deferral on investment earnings.

Rules on contribution limits

In 2018, the maximum annual contribution to an IRA is $5,500 (in general, married couples filing jointly can contribute a total of $11,000, even if only one spouse has income). Thereafter, the contribution limit will be adjusted for inflation. Individuals aged 50 and older are now able to take advantage of "catch-up" contributions to IRAs. The allowable catch-up contribution is $1,000 per year. Maximum contributions may not exceed earned income.
In addition, you can open an IRA or make contributions to an existing IRA as late as the deadline for filing a tax return for that year. That means you would have until April 15, 2019, to make your 2018 IRA contribution.

Tax treatment of IRAs

Contributions to a traditional IRA may or may not be deductible from your earned income in a given tax year depending on your situation. Income limits apply if either you or your spouse participates in an employer-sponsored retirement savings plan. Deductibility is phased out over certain ranges of income as follows:
Traditional IRA deductibility phaseout ranges for 2018*
$ in Thousands
  Single Filers Joint Filers
Those covered by an employer-sponsored retirement plan $63-$73 $101-$121
Those not covered by an employer-sponsored retirement plan, but filing a joint return with a spouse who is covered N/A $189-$199
*Based on modified adjusted gross income (MAGI).

Potential tax-deferred compounding

The ability to make tax-deductible contributions to a traditional IRA can help your current tax situation. But you may want to invest in an IRA whether or not your contributions are deductible. Why? The real advantage of investing in an IRA is potential tax-deferred compounding of any investment earnings over the long term.
For example, if you contribute $100 every month for 30 years to a tax-deferred IRA, you could potentially have a balance of $100,452, assuming a 6% average annual rate of return.Footnote 1

Change jobs but keep your retirement money

IRAs can also come in handy when you're about to leave jobs and need to move your 401(k) money. If your former employer requires that you withdraw your retirement money, you can move your distribution from your former employer's qualified retirement plan directly into a rollover IRA or your new employer's plan, if offered, and avoid owing current income tax on the distribution.
You could also choose to receive part or all of your money as a cash distribution. But any amounts withdrawn will be subject to taxes and may also be subject to a 10% early withdrawal tax if you are under age 59½.

Withdrawing from your IRA

Generally, any distribution you receive from an IRA before the day you reach age 59½ is subject to a 10% tax imposed by the IRS, in addition to federal and state income tax. Beginning at age 59½, you can withdraw money (of which any deductible contributions and investment earnings are taxable at your then-current income tax rate) from your IRA as desired without the 10% additional tax, whether or not you are still employed.
But, as with any rule, there are exceptions. Distributions before age 59½ are not subject to additional tax under certain circumstances, including when:
  • You become permanently disabled
  • You die before age 59½ and distributions are made to your beneficiary or estate after your death
  • You make withdrawals to pay deductible medical expenses
  • You make withdrawals for a qualified first-time home purchase (lifetime limit of $10,000)
  • You make withdrawals to pay qualified higher education expenses for yourself, a spouse, children, or grandchildren
By April 1 following the year in which you reach age 70½, you must begin withdrawals from your IRA. An advantage of taking only the required minimum distribution amount is that the balance continues to compound tax-deferred. However, if your distributions in any year after you reach age 70½ are less than the required minimum; you will be subject to an additional tax equal to 50% of the difference.

Footnote 1 This is a hypothetical example used for illustrative purposes only. It is not representative of any particular investment vehicle. It assume a monthly contribution of $100 and a 6% average annual total return compounded monthly. Your investment results will be different. Tax-deferred amounts accumulated in a traditional IRA are taxable on withdrawal.

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