The Basics of the Traditional IRA

By Mack Bekeza, CFP®

Hopefully, you enjoyed my piece on Roth IRAs, but what about Traditional IRAs? Don’t people ask me about those too? Well yes, they do! For those who earn too much to contribute to a Roth IRA, you may want to consider the Traditional IRA (or just IRA)

What is a Traditional IRA?

Established under the Employee Retirement Security Act of 1974, the Traditional Individual Retirement Account was established to allow American Citizens to contribute pre-tax dollars to not only reduce their taxable income for the year they contribute but to build a self-directed retirement portfolio. Before ERISA was enacted, individuals had to rely solely on things such as Pension Plans and Social Security to provide retirement benefits, both of which are regularly scrutinized due to the potential unreliability of these plans when it comes to providing ample income. Part of that scrutiny derives from the individual not being able to have discretion on how to invest their retirement nest egg, which the IRA helps solve. However, since individuals can take an “above the line” deduction for making IRA contributions, IRA withdrawals are treated as ordinary income, which is less favorable than passive income such as qualified dividends and long term capital gains taxes.  

Who can use an IRA

Anyone can establish and contribute to an IRA as long as they meet one requirement: 

1. They must have “Earned Income” for the year they contribute to an IRA

Earned Income? Isn’t any income considered “earned?” Well… the IRS has a different opinion. 

What is considered “Earned Income”

In short, the IRS considers you have “earned income” when you: 

1. Work for someone who pays you
2. You own a business or a farm and paid from said business or farm

However, they have a page dedicated to “earned income” and can found by clicking here. 

2019 and 2020 Deductibility Limits and Income Thresholds

For 2019 and 2020, you can contribute up to either $6,000 if you are under age 50 and $7,000 if you are over 50. However, whereas Roth IRAs have more technicalities when it comes to early withdrawals, IRAs have more technicalities when it comes to how much you can deduct your contributions. For those who are covered by an employer retirement plan like a 401(K), you will want to pay close attention to the table…well, two tables actually. Figuring out how much of your IRA contributions are deductible can be a little tricky. 

If you are covered by an Employer Retirement Plan

If you are NOT covered by an Employer Retirement Plan

After seeing these two tables, there might be a few things you are thinking…

What on earth is MAGI?

Your Modified Adjusted Gross Income (MAGI) is essentially your Adjusted Gross Income (AGI) with certain deductions and tax-exempt income added back. For those who are wondering what your AGI is, that is essentially your gross income minus “above the line” deductions such as student loan interest, alimony payments, etc. 

Your MAGI is an important number to know because it determines your eligibility for things such as IRA contributions, Medicaid, and subsidized health insurance plans. 

If my earned income was less than the annual maximum contribution amount, can I still contribute up to $6,000-$7,000 for 2019 and or 2020?

In short, no! If you meet the income thresholds to contribute the maximum annual amount to an IRA, your maximum annual contribution is either between $6,000-$7,000 or your total earned income, whichever is less. 

So essentially, the mass majority of working Americans can contribute to an IRA. However, if you are someone who recognizes how great the Time Value of Money can be, there might be something you are wondering about…

Can I establish a Traditional IRA for my minor child?

Does your minor child have earned income and meets the thresholds above? If the answer is yes, you can establish a Minor Traditional IRA for your child, although most choose to contribute to a Minor Roth IRA instead. And as with any account owned by a minor, you will be able to serve as the “custodian” for the account, meaning that you will have full control of the account until the child has reached 18-21 years of age, depending on your state of residence. 

Where can you open a Traditional IRA

Traditional IRAs can be opened at most financial institutions, including: 

• Banks
• Credit Unions
• Brokerage Firms such as Charles Schwab, Vanguard, Fidelity, etc. 
• Robo Advisors such as Betterment, WealthFront, etc. 
• Any other “Qualified Custodian”

How can you contribute to a Traditional IRA

Below are the most common methods for Traditional IRA Contributions: 

• Regular Contributions (i.e. ACH transfer from your bank account, depositing a check, bank wires, etc.
• Spousal Contributions: If you do not have earned income, but your spouse does, you can still make contributions to a Traditional IRA. Another great thing about this is that if your spouse has at least $12,000-14,000 of earned income (depending on if only one or both of you are ages 50 or over), both yours and your spouses IRAs can be fully funded!
• Rollover Contributions: If you have a 401(k) and are no longer working for that employer, you can rollover a 401(k) to a Traditional IRA. Please speak with your Financial Planner before doing this, this does not always make sense.

*One thing to note is that you can only contribute cash and cannot contribute securities*

What can you invest in using a Traditional IRA

With a Traditional IRA, you can invest in the following: 

• Individual Stocks
• Individuals Bonds
• Mutual Funds
• Exchanged Traded Funds (ETFs)
• Certificates of Deposits
• Covered Call Options
• Real Estate (a very limited amount of institutions and qualified custodians allow this)

Primary Benefits of a Traditional IRA

• You receive an “above the line deduction” for contributing if you meet the income thresholds 

A small above the line deduction can significantly change your tax liability, which is one of the largest benefits of an IRA

• Your money will grow tax-deferred 

Not being liable for taxes while your nest egg is growing can have a very positive impact on your account value over time!

• Eligibility for Tax Credits

Just like the Roth IRA, If you meet certain income thresholds based on your filing status, you may be eligible for something called the “Retirement Savings Contribution Credit”

• Your IRA assets are protected by Bankruptcy Law

IRA assets are protected under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. The protection amount is indexed by inflation every three years and Roth IRAs also receive this protection. As of 2020, up to $1,362,800, per person, is protected.

Primary Caveats of a Traditional IRA

• IRA withdrawals are treated as ordinary income for tax purposes 

For those who want to lower their tax bill during retirement, this will not help what so ever! Also, because of this, your actual usable retirement assets will be lower than what your account value is due to future tax liabilities. Another issue with this is that social security benefits may become taxable if your ordinary income reaches a certain threshold. 

• IRAs are subject to Required Minimum Distributions (RMDs) when you reach age 72 

When you reach the age of 72, you will be required to withdraw money from your IRA and pay ordinary income tax on the withdrawals. The withdrawal amount is based on the IRS’s Uniform Lifetime table and the percentage of your IRA that needs to be withdrawn increases with your age. 

• Withdrawals made before 59 ½ are subject to a 10% penalty 

Because IRAs are funded on pre-tax dollars, the penalty will be assessed to the full amount of the withdrawal. This is on top of the ordinary income tax that will be assessed on the withdrawal!

Are there exceptions to the 10% Penalty?

Yes! Although you will always be subject to ordinary income tax since contributions are made with pre-tax dollars. And as mentioned earlier, IRA early withdrawals are a bit more straight forward since you are not subject to a 5-year seasoning period like a Roth IRA. In short, if you are younger than 59 ½, you will be subject to the additional 10% penalty unless you are paying for:  

*First-time home purchase (up to $10,000 can be used for this penalty-free)

*Qualified education expenses 

*Unreimbursed medical bills (if expenses are more than 10% of your AGI)

*Health insurance premiums while you’re unemployed

*Due to a disability

*Made to a beneficiary or your estate after your death

*Substantially equal payments

*Due to an IRS levy

Has the CARES Act Provided relief for people who need to make early Traditional IRA withdrawals or retirement plans in general

Yes! For the 2020 Tax year, if you meet the qualifications stated by the CARES act, you may take distributions of up to $100,000 from an IRA or Employer Retirement Plan. These distributions will not be subject to the typical 10% early withdrawal penalty and income taxes can be spread over 3 years! People will also be able to re-contribute these distributions over the three year period as well. One thing to note that the $100,000 limit represents the aggregate of all retirement accounts. 

 Before you take on any investment or retirement strategy, it is vital that you seek out proper investment and tax advice beforehand. Investment performance is never guaranteed and investments may lose some or all of their value. On top of that, there may be severe tax consequences if withdrawals are taken improperly and can have a significant impact on your portfolio and retirement. Although we provide Investment Advice and Personal Financial Planning Services, we at MWM do not provide tax advice and any tax advice should be rendered by a licensed tax professional such as a CPA.