In this week’s post, I explain the basics of a traditional individual retirement arrangement (IRA). A traditional IRA is a special type of account that provides certain tax benefits to people saving for retirement.
Before discussing the features of a traditional IRA, it is important to remember that the type of investment account is distinct from the account’s investment holdings, as we covered in last week’s post. The account has its own rules and tax treatment independent from the investments held within the account. This post will explore some of the account-level rules and tax treatment for a traditional IRA.
Who can contribute to a traditional IRA?
Traditional IRAs are set up by individuals, as opposed to some other types of retirement plans (such as 401ks) that are set up through employers.
Anyone can make contributions to a traditional IRA if they have earned income from working. For example, someone who works for a company and receives a W-2 at the end of the year has earned income and can contribute. However, a retired person who just has income from passive investments (such as stocks and bonds), would not be able to contribute. A spouse who does not work outside of the home can also contribute, assuming their spouse has earned income and they file taxes jointly.
Other than contributions, a traditional IRA can also be funded by a rollover. A rollover is where assets are transferred from one retirement plan/account to another. Typically, this happens when someone rolls a 401k set up through a former employer over to an IRA. Rollovers typically do not have any tax consequences. We will explore rollovers in a future post.
How much can they contribute?
There is a limit to the amount someone can contribute to a traditional IRA each tax year. For tax year 2022, the limit is $6,000 for anyone under age 50 and $7,000 for those who are age 50 or over. The contribution amount cannot exceed the amount of earned compensation – someone who earns $1,000 at a part-time job cannot contribute a full $6,000 to a traditional IRA, they would be limited by their compensation and can only contribute $1,000. Rollovers are not contributions, so these limits do not apply to them.
Contributions can be made for a tax year up until the tax filing deadline for that tax year. For example, contributions for tax year 2022 can be made from January 1, 2022 up until April 15, 2023 (the tax return deadline for 2022).
Are contributions tax-deductible?
In many instances, contributions to a traditional IRA can be tax-deductible. When deductible, the contributions are reported as an “adjustment” to income, which reduces adjusted gross income (AGI) and reduces total taxes owed in the current year. To learn more about what an adjustment is and how it impacts a tax calculation, please read our recent post about income taxes, Basics Of Federal Income Taxes.
An adjustment will reduce taxes in the current year. Typically, the amount of reduction is equal to the adjustment amount multiplied by the tax rate. For example, a fully deductible $6,000 traditional IRA contribution made by a taxpayer in the 22% tax bracket will reduce current taxes by $1,320 (6,000 * 22%).
Because tax-deductible contributions are eventually taxed when withdrawn (will discuss in a moment), it is most accurate to describe a traditional IRA as a tax-deferred account. The payment of tax is being deferred into the future, perhaps 40+ years into the future.
The deductibility of a contribution is dependent on whether a taxpayer and his or her spouse (if applicable) are covered by a retirement plan at work and the taxpayer’s level of modified adjusted gross income (MAGI). Modified adjusted gross income (MAGI) is calculated by adding back certain items to adjusted gross income (AGI). If the account holder is receiving social security benefits, the calculation of MAGI is a little more complicated. Here is the basic formula for MAGI:
If the taxpayer and his or her (if applicable) are not covered by retirement plans at work, then the contributions will always be deductible. If they have work-related retirement plans, then the MAGI limits apply. These limits "phase-out" over a certain level of MAGI - between the lower and upper limits, a partial deduction would be allowed. All limits shown below are for tax year 2022:
If filing with single filing status, a traditional IRA contribution is fully deductible if:
Account holder is not covered by a retirement plan at work.
OR
Account holder’s MAGI is below $68,000 (phasing out to $78,000).
If filing with married filing jointly status, a traditional IRA contribution is fully deductible if:
Account holder and their spouse are not covered by retirement plans at work.
OR
Account holder is covered by a retirement plan at work and MAGI is below $109,000 (phasing to $129,000).
OR
Account holder is not covered by a retirement plan at work, but their spouse is covered by a retirement plan at work, and MAGI is below $204,000 (phasing to $214,000).
If contributions are not deductible, nondeductible contributions can still be made. Nondeductible contributions make the future taxability of withdrawals more complicated, which we will not cover in the post. Nondeductible contributions also are part of “backdoor” Roth IRA contributions, which are a popular way to fund a Roth IRA if a taxpayer’s income is too high. “Backdoor” Roth IRA contributions will likely be the subject of a future post.
Are investment earnings taxed?
Earnings in a traditional IRA account are also tax-deferred. Taxes are only paid when a withdrawal is made from the account. For example, if a traditional IRA account grows from $6,000 to $50,000 over a period of 30 years and throughout that period the account holder buys and sells many different investments within the account, they will still not owe any tax. The tax-deferred treatment is an especially nice feature when managing a portfolio, because the portfolio can be managed without having to be concerned with adverse tax consequences.
When can withdrawals be taken?
Funds can be withdrawn from a traditional IRA without penalty after the account holder reaches 59 and a half years old. There are a number of exceptions that allow for penalty-free withdrawals, before age 59 and a half, that are beyond the scope of this post.
Eventually, withdrawals are required from the account. These are called required minimum distributions (RMDs). RMDs start April 1 of the year after the account holder turns 72 years old, but they usually are taken in the year the account holder reaches age 72 and must be taken every year thereafter.
How are withdrawals taxed?
If all contributions were tax-deductible, then all withdrawals are fully taxable as regular income – the income receives no special tax treatment. If nondeductible contributions were made, at least some of the withdrawal will not be taxable, but the calculation is more complicated and beyond the scope of this post.
Example of a traditional IRA
Mary contributed $6,000 to a traditional IRA this year. $6,000 is the most she could contribute, because she is under 50 years old. Mary is not covered by a retirement plan at work and files her taxes under the single filing status, so her contribution is fully deductible. She is in the 32% tax bracket, so her federal income taxes are reduced by $1,920 this year. If this $6,000 grows at 8% a year for 40 years, she will end up with $130,347 in the account. During this period, all investment gains are tax-deferred. However, her withdrawals will be taxed at regular income tax rates. Because of the separation between the account and the investments within it (as discussed in last week’s post), Mary changes the investments in her account several times without tax ramifications. Here is a visual:
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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