IRAs: Traditional IRAs
Traditional IRAs are the original format for the program, and were introduced in 1974. The traditional IRA is designed to shelter income from taxes in order to encourage people to save for their retirement.
How does it shelter income? A couple of ways:
- Tax Deferral: In other words, dividends and other gains that the investments in a traditional IRA earn are not taxed in the year they’re earned. Because they get to stick around untaxed, the account will grow faster. You will have to pay taxes on them upon withdrawal of them, though.
- Tax Deductability: If you meet certain requirements, income invested through an IRA can give you a deduction on your tax return for that year. You’ll pay less in taxes that year!
In a Traditional IRA, all distributions are taxed at your normal tax rate for the year you get the distribution. The only exception to this is if part of the money you contributed didn’t qualify for the tax deduction on the front end. That portion has a “tax basis” already and won’t be taxed again.
The requirements for contributed income to not qualify change from year to year, so I’ll include them in a later post.
Due to the deduction, contributing to a traditional IRA can reduce your taxes while you’re in a high tax bracket. Once you start withdrawing after retirement, those contributions and their earnings are taxed at your normal tax rate for the year you withdraw them…which should be a lot lower, since you’re not earning as much in retirement. Because of this you can get considerable tax savings. Just remember: If you’re under fifty nine and a half you’ll have to pay an extra 10% penalty for withdrawing money from your IRA.
Here’s a short example to illustrate the paragraph above:
You contribute $100 to your traditional IRA at age 40, while you’re in a 28% tax bracket. It qualifies for the deduction, so you pay $28 less in taxes!
At age 70 you withdraw $100 (let’s ignore the gains for this, but they’d be in there too) and pay taxes at your normal rate on the distribution. Now that you’re retired, your tax rate has dropped to 10% and you pay $10 in taxes.
$28 – $10 = $18 of tax savings. You paid 18% less than you might have. That can add up!
Thanks for reading,