Last month, I wrote about how young adults should start saving for retirement as soon as possible – and how the Roth IRA is the perfect vehicle for many younger folks. This month, I’ll delve into more details about the Traditional IRA. The October 2014 issue of Money Magazine included the statistic that each day, more than 10,000 baby boomers enter retirement, yet only about twenty-five percent (25%) of workers age fifty-five (55) and older say they are doing a good job preparing for retirement. By beginning to save for retirement as soon as you start working, you will be helping to ensure that you are not another statistic. Saving using a Traditional IRA may be the right tool for you!
Like a Roth IRA, the contribution limit for 2014 is $5,500 a year for individuals under the age of fifty-five (55). Generally, earned income must be used to fund a Traditional IRA, but there is an exception for nonworking spouses. A working spouse can fund something called a “spousal IRA” for the nonworking spouse, allowing the couple to contribute up to a total of $11,000 for 2014 (or $13,000 for those 50 and older).
Contributions to a Traditional IRA may be fully or partially tax deductible, depending on your circumstances. Whether you qualify for the deduction depends on your income, filing status, whether you have access to an employee-sponsored retirement plan at work, and whether you receive Social Security benefits. Many people do not know that even if you have a 401(k) at work, you can maximize both the contributions of your workplace plan and an IRA; the caveat is that you may not be able to deduct all of your IRA contributions. This deduction is phased out based on your income. See IRS Publication 590 for more details on these requirements.
Generally speaking, the amounts in your Traditional IRA (including earnings and gains) are not taxed until they are distributed, which allows the IRA to grow much faster than its taxable counterpart, the Roth IRA. When you make withdrawals from your Traditional IRA account after age fifty-nine and a half (59 ½), these withdrawals are treated as ordinary income.
If you are eligible for both a Roth and a Traditional IRA, you may be better off with a Traditional IRA if you anticipate being in a lower tax bracket when you retire. By deducting your contributions now, you pay fewer taxes in the present. When you retire and start withdrawing money, you’ll be in a lower tax bracket, thereby paying fewer taxes in the future, too. If you anticipate being in the same or a higher tax bracket when you retire, you may instead consider contributing to a Roth IRA, which allows you to pay the income taxes now rather than later.