Traditional individual retirement accounts (IRAs) were first introduced in 1974, as part of the Employee Retirement Income Security Act (ERISA). Traditional IRA rules have been adjusted over the years, as the Internal Revenue Service has periodically raised annual contribution limits as well as income limits governing the tax deductibility of contributions, but the principles of these tax-advantaged retirement savings accounts have largely remained intact.
Traditional IRA rules begin with who is eligible to open or contribute to accounts. The answer is, nearly anyone with earned income, defined as wages, salaries, tips, self-employment compensation, taxable alimony, and the like. One cannot make an annual contribution to an IRA account that exceeds one’s earned income for the year. And one can’t contribute more than $5,000 (in 2012), or, for those aged fifty or more, $6,000, in any event. A twenty-year-old college student who earns $5,000 flipping hamburgers part-time in a given year, and a forty-five-year-old stockbroker who earns $450,000 in that same year, can contribute exactly the same amount to their respective IRAs: $5,000.
Roth IRA Rules Let You Save More
One of the big advantages to traditional IRAs is that, for most people, contributions are tax deductible. However, this benefit is subject to income limitations. If neither you nor your spouse (if you’re married) participates in a work-sponsored retirement plan (such as a 401[k]), your contributions to your respective IRAs are completely tax deductible. If you DO participate in such a plan at your place of employment and you are a single tax filer, as of 2012, you must earn less than $58,000 (as defined by your modified adjusted gross income, or MAGI) for your contribution to be fully tax deductible. If you earn between $58,000 and $68,000, your contribution will be partially deductible on a sliding scale; if you earn more than $68,000, your contribution will not be deductible at all.
For married persons filing jointly, the limitations are more complex. If you participate in a work-sponsored retirement plan, you can deduct the full amount of your IRA contribution only if your MAGI is $92,000 or below; between $92,000 and $112,000, and your contribution is partially deductible on a sliding scale; more than $112,000, and you can’t deduct any of your IRA contribution. If your spouse also participates in 401(k) or similar plan, the same restrictions will apply — and of course your MAGI will be identical, as you are filing your taxes jointly. However, if you are filing jointly but either you or your spouse does NOT participate in a work-sponsored retirement plan, the MAGI limits for that person are higher. A nonparticipating spouse can deduct the full amount of his or her traditional IRA contribution if the MAGI as shown on the joint tax return is $173,000 or lower; between $173,000 and $183,000, the nonparticipating spouse can deduct part of his or her contribution, on a sliding scale; and above $183,000, no deduction can be taken.
As with a Roth IRA, a traditional IRA grows tax free as long as interest, dividend, and capital gains income is kept in the account.
You can withdraw from your traditional IRA at any time, but generally a 10 percent penalty will be assessed if you make withdrawals before you turn 59½ years of age. (There are many exceptions, depending on how you use the money.) You MUST begin making withdrawals by April 1 of the year following the year in which you reach age 70½; this is referred to as the required beginning date. And it’s not enough to pull out just a few dollars; you must make minimal withdrawals each year after your required beginning date, calculated based on the amount of money in your IRA and other variables.
Withdrawals from a traditional IRA are taxed as ordinary income — at the same tax rate that would apply to earnings from wages, salaries, and most other forms of earned income. This assumes that your original contributions were tax deductible. If your traditional IRA contributions were partially or wholly nondeductible, an IRS tax form will enable you to determine the taxable portion of your distribution. And while you’re withdrawing distributions from your IRA, the part of your IRA that is not withdrawn continues to grow, tax-free.
This summary is meant as an introduction to traditional IRAs; special traditional IRA rules may be applicable to your circumstances, so be sure to research the matter as appropriate.
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