Traditional IRA Accounts 101

Traditional IRA accounts make sense for people in certain situations. After reading this article, you’ll know whether you should use your Traditional, your Roth, or both.

Have your cake and eat it, too!

Your allowed to have both a Traditional and Roth IRA. There’s no need to be all-or-nothing either way. In 2008, most people will be eligible to make $5,000 in IRA contributions. You can split this however you want between the two types (i.e. you can put $2,500 in each, or $1,000 in a Traditional and $4,000 in a Roth).

If you’re still unsure of what to do by the end of this article, talk to a financial advisor, or just strike a balance between the two based on your best judgment. It’s not rocket-science : )

Do you want your tax-break now or later?

This is the main question that will lead you to your answer. In IRAs, you get a nice tax break. If you’re making a lot of money and paying a lot in taxes now, then you can use that nice break now. If you’re not making too much money, and your current tax payments are not a burden, then take your tax break later. You will surely enjoy it.

  • Traditional IRA accounts afford you a nice tax-break right now.
    • You’re able to deduct Traditional IRA contributions from your taxable income, which lowers the amount of tax you pay in the current year.

Deducting the contributions effectively makes them pre-tax. This means that

  1. You’re holding the IRS’ money and earning money off of it for decades, which is sweet,
  2. You have to pay them when you take the money out, which sucks.

How do Traditional IRA withdrawals work? (new window)

Another big question

What tax bracket will you be in when you turn 60?

If you’re wealthy when you’re around retirement age, you’ll likely be in a high tax bracket. If you’re in a high tax bracket, you’ll have to pay through the nose on distributions from Traditional IRA accounts.

If you’re not wealthy when you’re in your 60s and 70s, then the tax payments will be more reasonable.

Forced distributions

Since Traditional IRA contributions are deductible (pre-tax), you’re effectively using Uncle Sam’s money to invest and enjoying the returns. Supposing you open your IRA when you’re 21, and invest in it until retirement (60ish), the IRS is patiently waiting for you to pay taxes for almost 40 years!

That’s nice of them, don’t you think?

So they made a rule that you have to begin making withdrawals (which are taxable) once you reach the age of 70 1/2. They’re called Required Minimum Distributions (RMDs), and as the name implies, they’re not optional. If you fail to make the distribution (withdrawal), you get penalized out the wah-zoo.

Are Traditional IRA accounts right for you?

If you’re young right now, most likely opening Roth IRA would make more sense for you (full disclosure: I love Roth IRAs and I think they’re the coolest thing since sliced bread).

If you would benefit highly from a nice, fat tax deduction right now, maybe you should investigate Traditional IRAs a little more. But keep in mind, you can always strike a balance between the two, which is probably a smart play.

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Traditional IRA Accounts 101 Traditional IRA accounts make sense for people in certain situations. After reading this article, you’ll know whether you sho …