Achieving your retirement goals may not be straight forward given there are many ways and tools to be financially secure enough to retire. One of those tools or options is to contribute to a traditional Individual Retirement Account (IRA). A traditional IRA is a way to save for retirement that provides contributors with tax advantages. The annual contribution limit for 2022 is $6,000 or $7,000 if you’re aged 50 or older. Even if you are already a contributor to an IRA or a 401K through your employer, you still can open up and contribute to a separate retirement plan. There are 3 main types of IRAs including traditional IRAs which we will focus in this article, Roth IRAs, and Rollover IRAs. Though it may be another discussion to choose between the three, all types have different advantages. Opening a traditional IRA offers the 3 following advantages below.
1. Tax Deductible Contributions
Although you are limited to contributing $6,000 to a traditional IRA, you have the ability to deduct all or part of your contributions from your taxable income. If you do not have an existing retirement plan at work, your deduction is allowed in full. However, if you have an existing retirement plan at work, your deduction may be limited. For example, if your single or head of household and your adjusted gross income is $68,000 or less, you are able to take a full deduction up to the amount of your contribution limit. With the same filing status, but making anywhere between $68,000 to $78,000, you are only able to partially deduct your contributions. See 2022 IRA Contribution and Deduction Limits below which is also exhibited on the official IRS site.
2. Tax Deferred Growth
One of the best benefits of a traditional IRA is tax-free growth meaning that any growth of your assets are tax free. Therefore, all of the capital gains that your investments earn in your IRA are not taxed until you make any withdrawals. An IRA allows you to invest in stocks, bonds, mutual funds, annuities, unit investment trusts, exchange-traded funds, and even real estate. Over the past 30 years, the S&P 500 index has returned an average of 10.7% per year meaning that if you were to allocate your IRA contributions towards an ETF that tracks the index closely, the return on your investment or capital gains are not taxed until you are required to take distributions at age 72. The taxes paid until you take a withdrawal is a huge benefit as it allows you to grow your contributions at a faster rate than it would in a taxable vehicle.
3. Penalty Exceptions
If you were to withdraw from your traditional IRA before 59 ½, the U.S. government charges a 10% penalty on early withdrawals from a Traditional IRA coupled with a varying state penalty tax. Realistically, although many plan to not make any withdrawals until 59 ½, there may be unforeseen expenses that may force you to withdraw funds early. Therefore, the IRA has several early withdrawal exceptions that allow you to withdraw from your account without being subject to the penalty fees. Some of the most notable penalty withdrawal exceptions include the following:
A) First Time Homebuyer
If you haven’t owned a home at any point during the last two years, you qualify for the first time homebuyer IRA exception which allows you to withdraw up to $10,000 from your traditional IRA to buy build, or rebuild a home. Note that you will avoid the 10% early withdrawal penalty, but will still owe income tax on any amount you withdraw and you are only able to use this exception once.
B) Higher Education Expenses
Withdrawals used to pay for loan payments while you or your family is in school is another early withdrawal exception. In addition to tuition, there are educational expenses that qualify for the exception including books, supplies, equipment, and room and board for students attending at least half-time.
C) Unreimbursed Medical Bills
Any unreimbursed qualified medical expense that does not exceed 10% of your adjusted gross income may qualify for a hardship withdrawal. Qualified medical expenses cover a broad array of practices including medical, dental and vision treatments. Another rule to this exception is that you are able to take the IRA hardship withdrawal to cover your qualified medical bills during the same year that you are billed.
D) Disability
If an IRA account holder is deemed totally and permanently disabled, the individual is eligible to take penalty-free withdrawals from the IRA so long as the individual can prove they can no longer perform any substantial gainful activity. Individuals collecting social security benefits usually are able to qualify for this exception.
Overall, a traditional IRA is simply another tax advantaged vehicle that allows you to reduce your taxes based on your contributions, allow your money to grow tax free until withdrawal, and withdraw your funds during qualified events. Though there are different types of IRAs, there is never a wrong time to open and fund a traditional IRA as it is always a good idea to put money away for your retirement. Though there are annual limits to your contributions, putting away as much as you can afford into an IRA accelerates the growth of funds. Generally, if you expect your income to be lower in retirement than what you are making now, a traditional IRA is an efficient vehicle because you are also expecting to be in a lower tax bracket in the future. Once your set on choosing which IRA best suits your needs and situation, there are several banks and brokerage firms that offer IRAs.
