What Is a Traditional IRA and How Does It Work?

Retirement savings accounts are one of the best ways to save for retirement. The easiest way to get started is by investing in a company-sponsored 401(k) plan. But did you know that it isn’t the only way to save for retirement?

A traditional IRA is a type of retirement account that you can maintain alongside a 401(k). It can help you save more and allow you to take a more active role in building your nest egg. This article will dive into what traditional IRAs are, how they work, and how you can get started investing in one.

What is a traditional IRA?

A traditional IRA — or individual retirement account — is a tax-deferred retirement account. It’s another tool you can use to grow your nest egg while you save for retirement.

Similar to a 401(k), traditional IRAs are tax-deferred. This means you can make traditional IRA contributions using pre-tax dollars. You won’t pay taxes on the income you use to contribute to your account but you will pay taxes on withdrawals you make later on in retirement. 

There are other tax benefits that come with traditional IRAs as well. If you open an account because you don’t have an employer-sponsored retirement option, any traditional IRA contribution you make will be a tax deduction. This can be part of your larger tax strategy, helping lower your adjusted gross income.

Traditional IRAs don’t have income limits, which means anyone with earned income can contribute money to one. However, there are required minimum distributions — you’ll have to start taking distributions when you turn 73, regardless of whether or not you want to.

How do traditional IRAs work?

Traditional IRAs are a type of retirement account that you can open with a brokerage firm or at a bank. Any traditional IRA contributions can be invested in assets like stocks and bonds, helping your money grow tax-deferred over time.

There are annual contribution limits for how much money you can set aside in a traditional IRA. In 2023, anyone under the age of 50 can contribute up to $6,500 per year. Those over age 50 can contribute up to $7,500 per year. Contributions are fully tax deductible if you’re not covered by a retirement plan at work.

If you do have a 401(k) at work there are income limits on whether or not you can deduct your contributions. You can always contribute, but if you earn over $73,000 as a single person, or $116,000 if you are married filing jointly there will be limits on what you can deduct. Here's the full chart from the IRS on these limits.

You can begin withdrawing from a traditional IRA at age 59 ½. If you make a withdrawal before then, you’ll have to pay taxes plus a 10% penalty. Regardless of when you plan to retire, you’ll have to start taking minimum distributions at age 73.

Related: How to save for retirement

Traditional IRA vs. other IRAs

The traditional IRA is the most basic individual retirement account. There are other types you can consider, especially if you don’t have a retirement savings option through your job.

Roth IRA

Besides traditional IRAs, Roth IRAs are another common type of retirement savings account. These plans lack tax deferral, utilizing after-tax dollars, and require you to pay taxes on your income before contributing. Consequently, Roth IRA contributions are not tax-deductible.

The benefit of a Roth IRA is that you can start taking withdrawals tax-free beginning at age 59 ½. Moreover, it imposes no capital gains taxes on earnings generated from your investments, and any gains from your Roth IRA stay with you, tax-free.

There are no required disbursements but there are penalties if you withdraw your investment earnings before age 59 ½. The good news is, you can withdraw your original contribution amount at any time penalty free.

One downside of Roth IRAs is the presence of income limitations that determine eligible contributors. Individuals earning over $153,000 (in 2023) or married couples filing jointly with an income surpassing $228,000 (in 2023) cannot make Roth IRA contributions.

Similar to a traditional IRA, there are contribution limits as well. Those younger than 50 can contribute $6,5000 per year, while those older than 50 can contribute up to $7,500 per year in 2023.

Here's more on Roth IRAs.

SEP IRA

A SEP IRA — or Simplified Employee Pension — is a type of traditional IRA designed for individuals who are self-employed, own a business, or earn income as a freelancer. For 2023, 25% of an employee’s compensation, or up to $66,000, can be contributed to a SEP IRA, whichever is less.

You can have an SEP IRA along with a traditional or Roth IRA, as well as participate in a retirement plan at work. Contributions across all of these accounts cannot exceed $66,000.

Contributions made in SEP IRAs may be tax deductible, but there are limits on who can make them. If an employer opens a SEP IRA on your behalf, your employer has to make the contributions. It isn’t a requirement to make a contribution on your behalf, so you’ll want to be mindful of that if you have an SEP IRA.

SIMPLE IRA

A SIMPLE IRA — or Savings Incentive Match Plan for Employees — is another type of traditional IRA for small businesses. Employees and employers with 100 employees or less, and no existing retirement plan options, can make tax-deductible contributions to a SIMPLE IRA.

For 2023, employees can contribute up to $15,500 per year. If they are enrolled in another employer-sponsored retirement plan, the total contribution limit is $22,500. 

Employers have two options for matching employee contributions. They can opt to do so on a dollar-for-dollar basis, up to 3% of the employee’s compensation. Or, an employer can choose to make a 2% nonelective contribution.

Individuals can contribute to a traditional IRA and a SIMPLE IRA. The benefit of a SIMPLE IRA is that it also includes employer contributions, increasing the total value of savings.

How to open a traditional IRA

To open a traditional IRA, you’ll first want to choose which type of account you want to open. You can opt for a tax-deferred traditional IRA at a bank or with a brokerage firm. 

Some banks treat traditional IRAs like savings accounts and you may or may not be able to invest in assets like stocks or bonds through those accounts. Others may offer actively managed IRAs through their wealth management or investment management divisions.

Once you decide on the account type, provide necessary information for opening, verifying identity, age, and employment.

From there you will need to fund the account. Some accounts do not require a minimum deposit. Others require a minimum in order to begin investing. Either way, you’ll need to deposit some money into the account in order to start purchasing assets.

Once the account is open, it's ready for investment. Select the types of assets for investment allocation and decide on the frequency of funding the account.

FAQs

Is a traditional IRA the same as a 401(k)?

A traditional IRA resembles a 401(k) but isn’t identical. Both are retirement accounts enabling you to invest in assets like stocks and bonds, contributing to building a nest egg for retirement.

The distinction lies in the account's sponsor. Employers usually sponsor a 401(k), with the option to match contributions. Anyone can open and contribute to a traditional IRA account through a bank or a brokerage firm, enjoying tax-deferred growth on investments.

Why would anyone use a traditional IRA?

Choosing a traditional IRA depends on your access to an employer-sponsored 401(k) plan through your job; it can help save money while providing tax advantages. Those lacking an employer-sponsored plan benefit from tax deductions, influencing adjusted gross income.

If you possess a 401(k) through your employer, a traditional IRA enables you to diversify investments. Employer-sponsored plans usually preselect investments, leaving you with no say in your choices. Managing a traditional IRA is entirely within your control, allowing you to invest in assets that align with your preferences and potentially enhance returns over time.

. . .