Traditional IRA
Encyclopedia
Established by the Tax Reform Act (TRA) of 1986, (Pub.L. 99-514, 100 Stat. 2085). A Traditional IRA is an individual retirement account
(IRA) in the United States
. The IRA is held at a custodian institution such as a bank or brokerage, and may be invested in anything that the custodian allows (for instance, a bank may allow certificates of deposit, and a brokerage may allow stocks and mutual fund
s). Unlike the Roth IRA
, the only criterion for being eligible to contribute to a Traditional IRA is sufficient income to make the contribution. However, the best provision of a Traditional IRA — the tax-deductibility of contributions — has strict eligibility requirements based on income, filing status, and availability of other retirement plans (mandated by the Internal Revenue Service
). Transactions in the account, including interest
, dividends, and capital gains, are not subject to tax while still in the account, but upon withdrawal from the account, withdrawals are subject to federal income tax (see below for details). This is in contrast to a Roth IRA, in which contributions are never tax-deductible, but qualified withdrawals are tax free. The traditional IRA also has more restrictions on withdrawals than a Roth IRA
. With both types of IRA, transactions inside the account (including capital gains, dividends, and interest) incur no tax liability.
According to IRS pension/retirement department as of July 13 2009, Traditional IRAs (originally called Regular IRAs) were created in 1975 and made available for tax reporting that year as well. Information pertaining to them from 1980 through the present is available at the IRS.gov website. by reviewing the instructions for the form 1040. The original contribution amount in 1975 was limited to $1,500 or 15% of the wages/salaries/tips reported on line 8 of the Federal form 1040 (1975).
Traditional IRA contributions are limited as follows:
!|Year
!|Age 49 and Below
!|Age 50 and Above
|-
| style="text-align: center" | 2005
|$4,000
|$4,500
|-
| style="text-align: center" | 2006–2007
|$4,000
|$5,000
|-
| style="text-align: center" | 2008–2010
|$5,000
|$6,000
|-
| style="text-align: center" | 2011 and beyond
| Indexed to inflation (in $500 increments)
| Indexed to inflation (in $500 increments)
|}>
If a taxpayer's household is covered by one or more employer-sponsored retirement plans, then the deductibility of traditional IRA contributions are phased out as specified income levels are reached (Modified Adjusted Gross Income is between).
!|Year
!|Married Filing Jointly or Qualified Widow
!|Married Filing Jointly (and you were not covered by an employee-sponsored retirement plan but your spouse was)
!|Single, Head of Household or Married Filing Separately (and you did not live with your spouse)
!|Married Filing Separately (and you lived with your spouse at any time during the year)
|-
| style="text-align: center" | 2007
|$83,000 and $103,000
|$156,000 and $166,000
|$52,000 and $62,000
|$0 and $10,000
|-
| style="text-align: center" | 2008
|$85,000 and $105,000
|$159,000 and $169,000
|$53,000 and $63,000
|$0 and $10,000
|-
| style="text-align: center" | 2009
|$89,000 and $109,000
|$166,000 and $176,000
|$55,000 and $65,000
|$0 and $10,000
|-
| style="text-align: center" | 2010
|$89,000 and $109,000
|$167,000 and $177,000
|$56,000 and $66,000
|$0 and $10,000
|-
| style="text-align: center" | 2011
|$90,000 and $110,000
|$169,000 and $179,000
|$56,000 and $66,000
|$0 and $10,000
|}>
The lower number represents the point at which the taxpayer is still allowed to deduct the entire maximum yearly contribution. The upper number is the point as of which the taxpayer is no longer allowed to deduct at all. The deduction is reduced proportionally for taxpayers in the range. Note that people who are married and lived together, but who file separately, are only allowed to deduct a relatively small amount.
To be eligible, you must meet the earned income minimum requirement. In order to make a contribution, you must have taxable compensation (not taxable income from investments). If you make only $2000 in taxable compensation, your maximum IRA contribution is $2000.
results in the converted funds becoming taxed in the year they are converted (with the exception of non-deductible assets).
Prior to 2010, two circumstances prohibit a conversion to a Roth IRA: Modified Adjusted Gross Income exceeding $100,000 or the participant's tax filing status is Married Filing Separately. With recent legislation, as part of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), the modified AGI requirement of $100,000 and not be married filing separately criteria was removed in 2010.
A transfer is normally initiated by the institution receiving the funds. A request is sent to the disbursing institution for a transfer and a check (made payable to the other institution) is sent in return. This transaction is not reported to the IRS
A rollover (sometimes referred to as a 60 day rollover) can also be used to move IRA money between institutions. A distribution is made from the institution disbursing the funds. A check would be made payable directly to the participant. The participant would then have to make a rollover contribution to the receiving financial institution within 60 days in order for the funds to retain their IRA status. This type of transaction can only be done once every 12 months with the same funds. Contrary to a transfer, a rollover is reported to the IRS. The participant who received the distribution will have that distribution reported to the IRS. Once the distribution is rolled into an IRA, the participant will be sent a Form 5498 to report on their taxes to nullify any tax consequence of the initial distribution.
Individual Retirement Account
An individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...
(IRA) in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
. The IRA is held at a custodian institution such as a bank or brokerage, and may be invested in anything that the custodian allows (for instance, a bank may allow certificates of deposit, and a brokerage may allow stocks and mutual fund
Mutual fund
A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors to buy stocks, bonds, short-term money market instruments, and/or other securities.- Overview :...
s). Unlike the Roth IRA
Roth IRA
A Roth IRA is a special type of retirement plan under US law that is generally not taxed, provided certain conditions are met. The tax law of the United States allows a tax reduction on a limited amount of saving for retirement. The Roth IRA is named for its chief legislative sponsor, Senator...
, the only criterion for being eligible to contribute to a Traditional IRA is sufficient income to make the contribution. However, the best provision of a Traditional IRA — the tax-deductibility of contributions — has strict eligibility requirements based on income, filing status, and availability of other retirement plans (mandated by the Internal Revenue Service
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
). Transactions in the account, including interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
, dividends, and capital gains, are not subject to tax while still in the account, but upon withdrawal from the account, withdrawals are subject to federal income tax (see below for details). This is in contrast to a Roth IRA, in which contributions are never tax-deductible, but qualified withdrawals are tax free. The traditional IRA also has more restrictions on withdrawals than a Roth IRA
Roth IRA
A Roth IRA is a special type of retirement plan under US law that is generally not taxed, provided certain conditions are met. The tax law of the United States allows a tax reduction on a limited amount of saving for retirement. The Roth IRA is named for its chief legislative sponsor, Senator...
. With both types of IRA, transactions inside the account (including capital gains, dividends, and interest) incur no tax liability.
According to IRS pension/retirement department as of July 13 2009, Traditional IRAs (originally called Regular IRAs) were created in 1975 and made available for tax reporting that year as well. Information pertaining to them from 1980 through the present is available at the IRS.gov website. by reviewing the instructions for the form 1040. The original contribution amount in 1975 was limited to $1,500 or 15% of the wages/salaries/tips reported on line 8 of the Federal form 1040 (1975).
Traditional IRA contributions are limited as follows:
!|Age 49 and Below
!|Age 50 and Above
|-
| style="text-align: center" | 2005
|$4,000
|$4,500
|-
| style="text-align: center" | 2006–2007
|$4,000
|$5,000
|-
| style="text-align: center" | 2008–2010
|$5,000
|$6,000
|-
| style="text-align: center" | 2011 and beyond
| Indexed to inflation (in $500 increments)
| Indexed to inflation (in $500 increments)
|}>
Advantages
- The main advantage of a Traditional IRA, compared to a Roth IRARoth IRAA Roth IRA is a special type of retirement plan under US law that is generally not taxed, provided certain conditions are met. The tax law of the United States allows a tax reduction on a limited amount of saving for retirement. The Roth IRA is named for its chief legislative sponsor, Senator...
, is that contributions are often tax-deductible. For instance, if a taxpayer contributes $4,000 to a traditional IRA and is in the twenty-five percent marginal tax bracketTax bracketTax brackets are the divisions at which tax rates change in a progressive tax system . Essentially, they are the cutoff values for taxable income — income past a certain point will be taxed at a higher rate.-Example:Imagine that there are three tax brackets: 10%, 20%, and 30%...
, then a $1,000 benefit ($1,000 reduced tax liability) will be realized for the year. Because qualified distributions are taxed as ordinary incomeOrdinary incomeUnder the United States Internal Revenue Code, the type of income is defined by its character. Ordinary income is usually characterized as income other than capital gain...
(the taxpayer's highest rate), the long-term benefits of the traditional IRA are only comparable to those of a Roth IRA (whose qualified distributions are tax free) if the current year tax benefit ($1,000 above) is reinvested, or if the pre-tax amount going into both is the same.
- Also, if a taxpayer expects to be in a lower tax bracket in retirement than during the working years, then a traditional IRA offers an increased incentive over the Roth IRA.
- Another advantage of a Traditional IRA is that the taxpayer gets the tax benefit immediately.
- With the Roth IRA, there may be a risk that over the next several decades Congress will decide to tax Roth IRA distributions; or that a national Value Added Tax will be imposed on purchases. Either alternative would subject the Roth beneficiary to effective double Federal taxation, once at the time of the deposit, once at the time of withdrawal.
Disadvantages
- One must meet the eligibility requirements to qualify for tax benefits. If one is eligible for a retirement plan at work, one's income must be below a specific threshold for your filing status.
- All withdrawals from a Traditional IRA are included in gross income and subject to federal income tax (with the exception of any nondeductible contributions; there is a formula for determining how much of a withdrawal is not subject to tax). If one's investment style is buy-and-hold or dividend-seeking, then a Traditional IRA is at a disadvantage since holding stocks in an IRA means they lose their favorable tax treatment given to dividends and capital gains.
- If one has a lot of disposable incomeDisposable incomeDisposable income is total personal income minus personal current taxes. In national accounts definitions, personal income, minus personal current taxes equals disposable personal income...
, a Roth IRA in effect shelters more assets from taxes on gains than a Traditional IRA does, because the contribution limits are the same, but the Traditional IRA is pre-tax, so it is equivalent to a lesser amount of Roth IRA money post-tax. Suppose someone in the 25% tax bracket has $5333 pre-tax income to invest. He can invest all of this post-tax (which is $4000) to a Roth IRA. But he can only invest a portion of it ($4000 pre-tax) to a Traditional IRA. In the future, again assuming 25% taxes, this will be equivalent to an initial post-tax investment of $3000. One would have to invest the remainder of the money that could not be contributed to the Traditional IRA to try to make up some of this difference; however, such an investment would not be tax-sheltered, so does not grow as fast as a tax-sheltered investment.
- Perhaps the greatest disadvantage of the Traditional IRA is its forced distributions based on age. Withdrawals must begin by age 70½ (more precisely, by April 1 of the calendar year after age 70½ is reached) according to a complicated formula. If an investor fails to make the required withdrawal, half of the mandatory amount will be confiscated automatically by the IRS. The Roth is completely free of these mandates.
- In addition to the distribution being included as taxable income, the IRS will also assess a 10% early distribution penalty if the participant is under age 59½. The IRS will waive this penalty with some exceptions, including first time home purchase (up to $10,000), higher education expenses, death, disability, unreimbursed medical expenses, health insurance, annuity payments and payments of IRS levies, all of which must meet certain stipulations.
Income limits
All United States taxpayers can make IRA deposits and defer the taxation of earnings. However, as explained below, the deposits are not deductible from income under certain circumstances. Accordingly, traditional IRAs are sometimes referred to as either "deductible" or "non-deductible."If a taxpayer's household is covered by one or more employer-sponsored retirement plans, then the deductibility of traditional IRA contributions are phased out as specified income levels are reached (Modified Adjusted Gross Income is between).
!|Married Filing Jointly or Qualified Widow
!|Married Filing Jointly (and you were not covered by an employee-sponsored retirement plan but your spouse was)
!|Single, Head of Household or Married Filing Separately (and you did not live with your spouse)
!|Married Filing Separately (and you lived with your spouse at any time during the year)
|-
| style="text-align: center" | 2007
|$83,000 and $103,000
|$156,000 and $166,000
|$52,000 and $62,000
|$0 and $10,000
|-
| style="text-align: center" | 2008
|$85,000 and $105,000
|$159,000 and $169,000
|$53,000 and $63,000
|$0 and $10,000
|-
| style="text-align: center" | 2009
|$89,000 and $109,000
|$166,000 and $176,000
|$55,000 and $65,000
|$0 and $10,000
|-
| style="text-align: center" | 2010
|$89,000 and $109,000
|$167,000 and $177,000
|$56,000 and $66,000
|$0 and $10,000
|-
| style="text-align: center" | 2011
|$90,000 and $110,000
|$169,000 and $179,000
|$56,000 and $66,000
|$0 and $10,000
|}>
The lower number represents the point at which the taxpayer is still allowed to deduct the entire maximum yearly contribution. The upper number is the point as of which the taxpayer is no longer allowed to deduct at all. The deduction is reduced proportionally for taxpayers in the range. Note that people who are married and lived together, but who file separately, are only allowed to deduct a relatively small amount.
To be eligible, you must meet the earned income minimum requirement. In order to make a contribution, you must have taxable compensation (not taxable income from investments). If you make only $2000 in taxable compensation, your maximum IRA contribution is $2000.
Converting a Traditional IRA to a Roth IRA
Conversion of a Traditional IRA to a Roth IRARoth IRA
A Roth IRA is a special type of retirement plan under US law that is generally not taxed, provided certain conditions are met. The tax law of the United States allows a tax reduction on a limited amount of saving for retirement. The Roth IRA is named for its chief legislative sponsor, Senator...
results in the converted funds becoming taxed in the year they are converted (with the exception of non-deductible assets).
Prior to 2010, two circumstances prohibit a conversion to a Roth IRA: Modified Adjusted Gross Income exceeding $100,000 or the participant's tax filing status is Married Filing Separately. With recent legislation, as part of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), the modified AGI requirement of $100,000 and not be married filing separately criteria was removed in 2010.
Transfers vs. Rollovers
Transfers and rollovers are two ways of moving IRA sheltered assets between financial institutions.A transfer is normally initiated by the institution receiving the funds. A request is sent to the disbursing institution for a transfer and a check (made payable to the other institution) is sent in return. This transaction is not reported to the IRS
A rollover (sometimes referred to as a 60 day rollover) can also be used to move IRA money between institutions. A distribution is made from the institution disbursing the funds. A check would be made payable directly to the participant. The participant would then have to make a rollover contribution to the receiving financial institution within 60 days in order for the funds to retain their IRA status. This type of transaction can only be done once every 12 months with the same funds. Contrary to a transfer, a rollover is reported to the IRS. The participant who received the distribution will have that distribution reported to the IRS. Once the distribution is rolled into an IRA, the participant will be sent a Form 5498 to report on their taxes to nullify any tax consequence of the initial distribution.