Today, the unprecedented number of Americans reaching retirement age highlights the importance of having a good retirement plan. Individuals have a number of options, both public and private. For nearly twenty-five years, the traditional IRA retirement account savings plan has been among the most popular choices. The traditional IRA program was created with the passage of the Tax Reform Act of 1986, and has been a great success ever since.
Benefits of a Traditional IRA
The key incentive for individuals to use a traditional IRA plan is the fact that contributions to a traditional IRA plan are generally tax-deductable. Individuals under age 50 can contribute up to $5,000 per year to a traditional IRA plan and have it count as a deduction from taxable income. When money is later withdrawn from the traditional IRA account, it is simply counted as ordinary income.
For individuals who plan on having modest retirement incomes compared to their earnings while working, the traditional IRA can save money. For example, a good wage earner might have a marginal tax rate of 35% while working. When he or she contributes $5,000 to his or her traditional IRA account, this individual will defer $1750 in income taxes. Later, when this individual retires, his or her yearly retirement income may be much lower, and subject to a lower marginal tax rate. If withdrawn under a 15% marginal tax rate, the total tax paid on the same $5000 is only $750. That’s a total savings of $1000 on a $5000 contribution. When you also take into account the effects of inflation, and the long time-value of the tax deferral, the traditional IRA becomes a very effective tool for retirement savings.
Drawbacks of a Traditional IRA
The Traditional IRA is not without its disadvantages, however. Traditional individual retirement accounts are not necessarily the best option for every individual. For those who plan to have a higher marginal tax rate during retirement than during their working years, contributions to a tratidional IRA can sometimes result in more taxes being paid. This case is much like the first example above, only in reverse.
Moreover, traditional IRA plans have a great deal of additional rules and restrictions. First, certain individuals may not qualify for traditional IRA contributions is they are already eligible for a retirement plan through their employer. Second, the IRS imposes a 10% penalty for withdrawal from a traditional IRA account before age 60. Finally, withdrawal from an IRA account must begin once an individual reaches age 70.
In this article, we have explored the bennefits & drawbacks of the Traditional IRA.