As you plan for your retirement, you’ll likely consider opening and managing several kinds of retirement accounts. One of the most commonly used retirement accounts is a traditional IRA. Let’s take a look at this account, how it works and the best ways to manage it effectively.

What is a traditional IRA?

A traditional IRA is a tax-advantaged retirement savings account designed to help individuals accumulate funds for their post-employment years. Contributions made to a traditional IRA may be tax-deductible in the year they are made, providing an immediate reduction in taxable income. Earnings and gains are generally not taxed until the account holder begins taking distributions.

How do traditional IRAs work?

Here’s a quick rundown of how traditional IRAs function:

• Contributions. Individuals under the age of 70½ and having earned income can contribute to a traditional IRA. Contribution limits are set annually by the Internal Revenue Service (IRS) and may vary based on factors such as age and income level.

• Tax deductibility.  Contributions to traditional IRAs are generally tax-deductible. This means the amount contributed can be claimed on the account holder’s tax return, often significantly reducing their taxable income. 

• Tax-deferred growth. Once funds have been contributed to a traditional IRA, they grow, tax-deferred. This means that investment gains, dividends and interest will accumulate without triggering immediate taxes, thus allowing the account to potentially grow faster over time.

• Required minimum distributions. The IRS mandates that individuals must start taking required minimum distributions (RMDs) from their traditional IRA by April 1 of the year following the calendar year in which they turn 72. Withdrawals on traditional IRAs are taxed, and RMDs ensure that the government collects taxes on the funds that have been growing tax-deferred.

• Early withdrawal penalties. Withdrawals from a traditional IRA before the age of 59½ typically result in a 10% early withdrawal penalty. However, there are some exceptions to the penalty, such as using funds for qualified education expenses, first-time home purchases or certain medical expenses.
  

What are the benefits of traditional IRAs?

In addition to the advantages mentioned above, including tax-deductible contributions and tax-deferred growth, there are other benefits to traditional IRAs.

First, IRAs offer flexibility in investment choices. You can choose from investing your IRA funds in stocks, bonds, mutual funds and more. This flexibility allows you to tailor your investments based on your risk tolerance and financial goals.

Also, opening a traditional IRA offers the owner the potential for being in a lower tax bracket during retirement. This means that when they make withdrawals from their IRA during retirement, the withdrawals can be subject to lower taxes than the tax rate applied during their working years.

What do I need to consider before opening a traditional IRA?

There are several important factors to consider before opening an IRA:

• You’ll need to take RMDs during your retirement. Failing to take the mandated distributions can result in high penalties. 

• Withdrawals are subject to income tax, so it’s important to consider these tax consequences when deciding if an IRA is the right choice for you. 

• You’ll need to pay a penalty for any early withdrawals (if you make them). Any withdrawals made before the age of 59½ can trigger a 10% penalty in addition to income taxes. It’s crucial to understand the exceptions and plan your withdrawals strategically to minimize penalties.

Your tax credits and deductions will be affected by the IRA. Individuals earning a high income who are covered by a workplace retirement plan may face limitations on their ability to deduct traditional IRA contributions. This can impact their eligibility for certain tax credits and deductions.