A traditional IRA is a tax-advantaged retirement savings plan that allows you to invest pre-tax dollars that can grow until you access them in retirement.
Traditional IRAs are typically something you’d open on your own, but they can also be offered through an employer.
Because of the way it’s taxed, an IRA can work well with other parts of your financial plan to help you manage the impact of taxes now and when you’re in retirement.
There are lots of ways to save for retirement. You may already be contributing to a 401(k) through your employer, but a good retirement strategy often includes multiple savings plans—including IRAs.
Like a 401(k), an individual retirement account (IRA) allows you to defer taxes on money you save for retirement. You can open an IRA on your own, or your employer might offer an IRA in addition to or instead of a 401(k).
But before doing so, you’ll want to understand the different types of IRAs, as they have different eligibility requirements, contribution limits and tax requirements. Whether you have a traditional IRA or a Roth IRA, for example, influences how and when you pay taxes on your money.
We’ll explain how an IRA works and break down some of the different types of IRAs, showing how they compare to one another and other retirement savings plans.
What is a traditional IRA, and how does it work?
With a traditional IRA, you’ll contribute pre-tax dollars to your retirement account, and then your money will grow tax-free until you withdraw it in retirement. Once you reach retirement age (59½), you can begin withdrawing your savings. Eventually, the IRS will require you to start taking distributions (known as required minimum distributions, or RMDs) and to pay tax on that money. In 2023, RMDs start in the year that you turn 73. Withdrawals are taxed at your regular income tax rate in the year that you make withdrawals (also called distributions).
Who can contribute to a traditional IRA?
To be eligible to contribute to a traditional IRA, you need to be earning an income. (A non-working spouse can also contribute as long as their spouse is earning an income and the couple files their taxes jointly.)
Because of its tax advantages, the IRS puts limits on how much you can contribute to an IRA each year. The limits apply across any traditional or Roth IRAs that you have. In 2023, you’re able to contribute up to $6,500 (or $7,500 if you’re age 50 or older) across all your IRAs. You’ll want to be mindful that you don’t overcontribute to your IRA, or you could face some unintended tax consequences.
Depending on your modified adjusted gross income (MAGI) a nd whether you or your spouse has a retirement plan through an employer, you also may be eligible to deduct your contributions on your taxes.
Can you cash out a traditional IRA?
The goal of putting money into an IRA is to allow it to grow until you’re ready to take it out in retirement (and to take advantage of the tax benefits the account offers). However, if you want to withdraw money before you reach retirement age (59½), you may be subject to a 10 percent tax penalty (in addition to the income tax you’d pay on the withdrawal).
However, there are a few situations in which you may not have to pay the 10 percent penalty for withdrawing funds early (if you meet the requirements), like covering financial hardship, supporting a new disability, funding higher education expenses, paying for medical expenses not covered by insurance or purchasing a first home.
Additional types of IRAs
If you enroll in an IRA on your own, you’d enroll in a traditional IRA. If your employer offers an IRA as part of your compensation package, you’ll likely enroll in either a SEP-IRA or a SIMPLE IRA. You can also opt to enroll in a Roth IRA.
Though a SEP-IRA is available to a business of any size, it’s often used by people who are self-employed or who own a business with few employees, because it doesn’t carry the start-up and operating costs that other retirement plans do. To open a SEP-IRA, you first need to set up a SEP Plan. In order to be eligible for a SEP Plan, you must:
Be at least 21 years old.
Have worked for your employer for the last three of the last five years.
Have made at least $750 (in 2023).
Contributions are made by the employer (not the employee), so the contribution limits are different from a traditional IRA. In 2023, an employer can contribute up to 25 percent of an employee’s compensation or up to $66,000 to a SEP-IRA.
A SIMPLE IRA, or Savings Incentive Match Plan for Employees, is also set up through an employer, but both employees and the employer can contribute. An employer is able to offer a SIMPLE IRA if they do not already offer another retirement savings plan. It’s another option typically used by smaller companies (typically fewer than 100 people).
To be eligible for a SIMPLE IRA, an employee needs to have earned at least $5,000 in the last two years (not counting the current calendar year) and be projected to make at least $5,000 in the current year.
Though employees can choose whether or not to contribute to the SIMPLE IRA, the employer is required to contribute some amount each year. Employers can either contribute a matching contribution of up to 3 percent of the employee’s compensation or make a 2 percent nonelective contribution (in the event an employee does not contribute).
A SIMPLE IRA also has its own individual contribution limits. An employee can choose to contribute up to $15,500 in 2023, and employees aged 50 or over are also eligible to contribute an additional $3,500 in catch-up contributions.
A Roth IRA works similarly to a traditional IRA, but the most notable difference between a traditional IRA and a Roth IRA is how they’re taxed. With a Roth IRA, you’d pay taxes on the money before you contribute it. Then you’re able to withdraw the money tax-free in retirement (as long as you wait until retirement age). Another benefit of a Roth IRA is that you may be able to deduct funds before retirement age if you use the money for certain purposes, like funding qualified education expenses or buying a first home.
Roth IRAs also have an added contribution limit with regard to your income. In order to contribute to a Roth IRA, your MAGI needs to be less than a certain amount; otherwise, you may only be able to contribute a reduced amount (or you may not be able to contribute at all). Unlike with a traditional IRA, you’re not able to deduct any contributions you make to a Roth IRA.
Is a traditional IRA the same as a 401(k)?
Though an IRA is another great tax-advantaged way to save for retirement, a traditional IRA and a 401(k) are not the same thing. There are some key differences between the two, including:
A 401(k) is offered through an employer. A traditional IRA is an account you open on your own.
Traditional IRAs have lower contribution limits than 401(k)s do. In 2023, you can contribute up to $22,500 (or $30,000 if you are 50 or older) to a 401(k), but you can contribute only $6,500 (or $7,500 if you’re age 50 or older) to an IRA.
With a 401(k), you’re limited to the investment options offered through your employer’s plan. A traditional IRA can sometimes have more investment options.
How an IRA compares to other retirement accounts
Each retirement savings plan offers its own unique benefits and downsides. Here is how some of the most common retirement savings plans compare to a traditional IRA:
What are the benefits of a traditional IRA?
As with many retirement savings plans, a traditional IRA affords certain tax advantages as you save for retirement, like deducting your contributions on your tax return.
Another benefit of a traditional IRA is that anyone making an income can contribute to one. You don’t need to be employed to open one (as you do with a 401(k)), and you don’t have to have to make less than a certain amount to contribute (as you do with a Roth IRA).
And though you’re not able to borrow against a traditional IRA like you can with a 401(k), an IRA gives a bit more flexibility on early withdrawals without penalty, provided you meet the eligibility requirements.
What are the downsides of a traditional IRA?
One downside of a traditional IRA is that it has a much lower contribution limit than other retirement savings options. With a traditional IRA, you’ll also be subject to annual required minimum distributions (RMDs).
Because of the timing of when you pay taxes, a traditional IRA could ultimately have a larger tax responsibility than a Roth IRA, depending on your income level at the time you contribute vs. when you withdraw. While no one knows what will happen in the future, current tax rates are historically low. With the government’s rising debt, there’s a strong possibility that tax rates could rise in the future. So, it’s likely that the tax rate when you retire will be higher than it is now. (A tax advisor and financial advisor can help you with strategies to stay in a lower tax bracket in retirement to minimize the impact of taxes.)
Who should use a traditional IRA?
A traditional IRA can be a good option for anyone, but the key is to be strategic with how it works with other retirement plans you have. In fact, diversifying your retirement savings with a mix of retirement accounts—like a traditional IRA (or Roth IRA) and a 401(k)—can help you maximize the tax benefits of each account.
Each financial situation is different, so a helpful way to develop your retirement savings plan is by working with a financial advisor. A Northwestern Mutual financial advisor can take a look at your retirement goals, your existing savings plans and your potential options to help you create a retirement plan that will help you feel more confident about your ability to generate the income you’ll need to live the life you want in retirement.
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