Many more people, of course, are saving for retirement by means of the 401(k), an employer-sponsored plan, and other financial vehicles as well. The traditional IRA, for example, is worthy of consideration by any investor with earned income.
Understanding Traditional IRAs
The number of categories of investment accounts ensures that some, such as the traditional IRA, might be overlooked. This IRA, however, is a powerful retirement-savings tool you can open at a brokerage or a bank.
Unlike the Roth IRA, you can contribute to a traditional IRA regardless of your income levels, assuming that you meet other criteria, including that pertaining to earned income. The best traditional IRA will vary from person to person, but many have the same features and investment options.
Traditional IRA Contributions
The Internal Revenue Service sets the maximum allowable contributions to a traditional IRA. For 2021, the maximum is $6,000 for those younger than 50 and $7,000 for those 50 and older. As this restriction indicates, the limit is per taxpayer, not per account.
Regardless of age, you can split your IRA contribution into two or more IRA accounts. For instance, if you're younger than 50, you might contribute $3,000 to a Roth IRA and $3,000 to a traditional IRA in 2021.
To contribute to a traditional IRA, you must have earned income from wages or other sources. What's more, your earnings must be equal to or greater than the amount of your IRA contribution(s). For instance, you are limited to a $4,000 IRA contribution if your total earned income is $4,000.
A traditional IRA can be a great way to supercharge your nest egg by staving off taxes while you're building your savings. You get a tax break now when you put in deductible contributions.
In the future, when you take money out of the IRA, you pay taxes at your ordinary income rate. That means you can end up with hundreds of thousands of dollars more by maxing out your contributions to an IRA each year rather than putting the funds in a regular savings account.
If IRS rules prevent you from making deductible IRA contributions, you can still use your IRA account as an investment vehicle. Just make sure that your nondeductible contributions don't exceed the limits set by the IRS. For 2021, the annual limit is $6,000. If you're age 50 or older, that limit is $7,000.
When you withdraw your nondeductible contributions from your IRA, you will have already paid taxes on those funds. The earnings on those non-deductible contributions, but not on the nondeductible contributions, are subject to tax. But the handling of the distribution of the cash from your account gets somewhat complicated at this point.
Rather than just removing the after-tax contributions separately as tax-free withdrawals and treating them as such, each withdrawal from a traditional IRA account is treated as a combination of nondeductible contributions, tax-deductible contributions and the earnings on both.
For instance, assume you have a $500,000 traditional IRA that includes nondeductible contributions in the amount of $50,000, which equals 10 percent of the account's balance. Also, assume you want to withdraw $10,000. In this case, 10 percent of your IRA balance, or $50,000, consists of nondeductible contributions. Consequently, 10 percent of the $10,000 withdrawal, or $1,000, is a tax-free withdrawal. You must pay tax on the remaining $9,000.
As the example illustrates, the calculation is withdrawal-specific, meaning the ratio can change with each withdrawal. So, you calculate the figure with each account withdrawal.
- You can make contributions to your Individual Retirement Account for the tax year up to the due date for filing your return, generally April 15.
- You can have all or a portion of your Income Tax Refund paid directly to your Traditional IRA. See IRS Form #8888 for details.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.