What Is a Traditional IRA?
A traditional IRA is a type of retirement savings plan that allows the holder to invest money tax-free towards retirement. As long as the holder does not make withdrawals from the IRA, he or she is not required to pay taxes on it. However, once the holder begins to make withdrawals in retirement – or if he or she makes an early withdrawal from the account – taxes must be paid on it.
Who Can Benefit from a Traditional IRA?
A traditional is not an employer-sponsored plan, which means that you cannot get this type of plan if your employer provides you with retirement benefits. However, you can open it as a supplementary plan to your existing retirement account if you want to and are able to save more. It is also a good plan for self-employed, part-time and contract workers who don’t have an employer-sponsored plan. They are a good choice for self-employed workers who make a moderate amount of money and who have a fairly steady income from year to year.
Traditional IRA Rules
The only eligibility rule for opening a traditional IRA is the ability to pay into the account on a regular basis. However, the custodian institution such as a bank or brokerage that holds the account may impose additional rules. The custodian institution also decides what type of investments are allowed in addition to cash. For example, some institutions may allow certificates of deposit and stocks to be invested in IRAs.
Advantages of a Traditional IRA
The biggest advantage of a traditional IRA is that the holder pays into the account before paying taxes, which means that more money can be invested than could be with a post-tax plan such as a Roth IRA. More money invested in the account also means larger gains over time. Income in a traditional IRA is not taxed until it is withdrawn from the account, whether this is done after retirement or before. The money you invest in a traditional IRA is considered safe from creditors, but it cannot be used as collateral when taking out loans.
Disadvantages of a Traditional IRA
While a traditional IRA has many advantages, it is only available to certain classes of workers. Self-employed workers or workers who do not have an employer-sponsored retirement are generally eligible for traditional IRAs. Workers who already have an employer-sponsored account may supplement their retirement income with a traditional IRA, but only if their annual income falls below a specific threshold. While the tax benefits of traditional IRAs are a major advantage during the investment period, they can sometimes turn into a drawback when the time comes to withdraw funds. Tax benefits are a loan on the money that must ultimately be paid back when the time comes to withdraw funds from the account, whether this is being done at the time of retirement or before retirement in the case of an emergency, though the latter is not recommended.
Managing a Traditional IRA
Traditional IRA accounts are managed by banks or brokerage firms that act as custodians for the money in the account. While account holders are encouraged to research the firm before investing to make sure that they are trustworthy and reliable, once a good custodian has been found, the holder does not have to spend a lot of time or effort managing the money in the account. He or she will be issued regular statements about the state of the account, and can always contact the financial adviser assigned to the account with questions.
For individuals who do not have an employer-sponsored retirement account, or who would like to supplement that account, a traditional IRA is a good investment choice.