A Guide to Traditional IRAs: Everything You Need to Know

What Is a Traditional IRA?

A traditional individual retirement account (IRA) is a tax-advantaged account that allows you to contribute income toward retirement investments. These contributions are made with pre-tax dollars, so you pay no tax at the time of the contribution. Instead, you will make relevant tax payments when you withdraw the funds. Unlike 401(k) accounts, IRAs are available to individual investors without sponsorship by an employer.

A traditional IRA may be a good option if you’re considering opening a retirement account. However, knowing the rules governing these accounts is crucial to save for retirement and avoid penalties effectively.

Key Takeaways

• Traditional IRAs allow individuals to set aside pre-tax dollars for investment toward retirement.
• Account holders pay taxes on the contributions and earnings for a traditional IRA upon withdrawing from the account.
• The IRS typically levies a 10% tax penalty levied on IRA withdrawals made before the account holder turns 59½ years old.
• Alternatives to traditional IRAs include Roth IRAs, SIMPLE IRAs, and SEP-IRAs.

How a Traditional IRA Works

Traditional IRAs are set up through providers such as Vanguard, Fidelity, or Charles Schwab. Investors make contributions within certain limits set according to age. They may direct certain aspects of how those contributions are invested, such as the breakdown of stocks and bonds or via individual mutual funds.

Tax Treatment of Traditional IRAs

Contributions to a traditional IRA are made from pre-tax income. In some cases, contributions may be tax-deductible. Typically, investors without access to employer-sponsored retirement plans are more likely to be able to deduct contributions to a traditional IRA.

Contribution Limits for Traditional IRAs

If you are under age 50, you may contribute a total of $7,000 to traditional and Roth IRAs in 2024 and 2025. If you are age  50 and above, you may contribute an additional $1,000 in catch-up contributions for a total of $8,000 per year.  These limits include all contributions, meaning that the total contribution to all IRA accounts cannot exceed $7,000 or $8,000, depending on your age.

Note

In 2024, you may make IRA contributions until April 15, 2025.

Early Withdrawals: Rules, Penalties, and Exceptions

Traditional IRA withdrawals are subject to income tax for the year in which they are disbursed. Additionally, the IRS levies a 10% early withdrawal tax for investors who take a distribution before age 59½.

There are exceptions for which the 10% penalty tax does not apply. These include but are not limited to:

• Birth or adoption expenses for a new child (up to $5,000)
• Death or disability of the account holder
• Expenses for recovery from a federally recognized disaster (up to $22,000)
• Cases of domestic abuse
• Qualified higher education expenses
• Emergency family expenses (typically up to $1,000 per year)
• First-time homebuying expenses (up to $10,000)
• Unreimbursed medical expenses equal to greater than 7.5% of the taxpayer’s AGI
• Health insurance costs while unemployed

Required Minimum Distributions

The IRS requires investors to take regular distributions from traditional IRAs once they reach a certain age. If you turn 72 before Dec. 31, 2022, you’ll need to take these required minimum distributions (RMDs) by age 72; if you turn 72 after that date, you’ll need to take RMDs by age 73.

Tip

The amount of these minimum withdrawals is calculated based on the account balance at the end of the previous year and your life expectancy.

Having a Traditional IRA and a 401(k)s or Employer Plans

If you have an employer-sponsored retirement plan like a 401(k), you may also invest in IRAs. However, if you have a 401(k) as well as an IRA, depending on your income, you may be unable to deduct IRA contributions.

Pros and Cons of Contributing to a Traditional IRA

Benefits of a Traditional IRA

• Ability to set up a traditional IRA separate from (and in addition to) employer-sponsored retirement accounts like 401(k)s
• May provide tax advantages at retirement if you expect to be in a lower tax bracket then than you are now
• Contributions may be tax-deductible

Drawbacks of a Traditional IRA

• Lower annual contribution limit compared to 401(k) accounts
• Must pay taxes on distributions in the year they are made
• Early withdrawal penalties in most cases for individuals under 59½ 

Traditional IRAs vs. Other IRAs

Traditional IRA vs. Roth IRA

Traditional and Roth IRAs are very similar, except that Roth IRAs make use of post-tax income for contributions. This means that Roth IRA distributions are generally not taxed. The 10% early withdrawal penalty tax is only levied on distributions of Roth IRA earnings; investors may typically withdraw their contributions without penalty so long as the fund has been active for at least five years.

Traditional IRA vs. SIMPLE IRA

SIMPLE IRAs allow both employees and employers to contribute. These accounts are offered by employers who may be unable to provide other retirement plans.

Traditional IRA vs. SEP-IRA

Simplified Employee Pension Plan IRAs (SEP-IRAs) function similarly to traditional IRAs, except they provide employers a way to contribute toward an employee’s retirement. The contribution limits are higher for a SEP-IRA than a traditional IRA, but typically only employers are allowed to make contributions.

Here’s a comparison of how the four main types of IRAs compare with one another: 

How To Open a Traditional IRA

The steps to opening a traditional IRA include:

1. Select an IRA provider. Major providers include TIAA, Vanguard, Fidelity, and more.
2. Apply through the provider. You’ll need to provide personal information and financial details and specify the type of IRA you want to open.
3. Fund the account. Make a contribution from an existing bank account or set up a rollover from a previous retirement account.
4. Select investment options. Specify any investments you would like the account to target. This may mean particular stocks, mutual funds, bonds, and so on, or it may be a broader breakdown of stocks vs. bonds.

Is a Traditional IRA Right for You?

Traditional IRAs are a good option if you’re looking to contribute pre-tax dollars to a retirement account separate from an employer-sponsored plan. They are particularly appropriate if you anticipate being in a lower tax bracket at the time of retirement when you will pay taxes on distributions.

What Happens if I Contribute More Than the Annual Limit to a Traditional IRA?

Overcontributing to a traditional IRA incurs a 6% penalty tax. In order to correct the situation, you must withdraw any excess contributions or apply them to the next year’s limit.

Should I Choose a Traditional IRA or a Roth IRA?

The primary difference between traditional and Roth IRAs is when your contributions and earnings are taxed. If you prefer to be taxed when you contribute, select a Roth IRA. If you prefer to be taxed upon distribution, select a traditional account.

How Much Money Do I Need To Open an IRA?

There is no government-mandated minimum to open an IRA, although some providers may set their own minimums.

The Bottom Line

Traditional IRAs are individual-directed retirement accounts that use pre-tax dollars for investment. They have lower contribution limits than 401(k)s but do not require employer sponsorship. While investors can direct how their contributions are invested, often the best approach is to determine an appropriate level of risk, target a broad range of assets through a mutual fund or similar option, and hold for the long term.