What Is a Traditional IRA?
Individual Retirement Account
Individual Retirement Arrangements (IRA) exist in many forms. As of 2011, there are approximately 45 million IRAs. The most common type is the IRA or individual retirement annuity to which any person with earnings from employment may contribute. These type of IRA plans are referred to as contributory IRAs. IRAs that are used to receive assets distributed from other retirement plans are called rollover IRAs. Roth IRAs combine the features of a regular IRA and a savings plan to produce a hybrid that adheres to its own set of rules. Whereas, SEPs and SIMPLE IRAs are technically IRAs even though their rules are quite similar to those of qualified plans.
The Traditional IRA is the most common type of retirement account. Unlike, a SEP IRA or Solo 401(k) Plan, a Traditional IRA is established by an individual not an employer.
In 1974, the Employee Retirement Income Security Act of 1974 (ERISA) became law and created IRAs. IRAs were generally created to supplement retirement income and less the burden on social programs, like Social Security.
An IRA, like the trust under an employer's qualified plan, is exempt from tax pursuant to Internal Revenue Code Section 408(e)(i), and an individual maintaining an IRA usually is not taxed on principal or earnings of the account or annuity until they are distributed by the trustee, custodian, or insurance company. A deductible contribution to an IRA thus offers the same tax advantage as an employer's contribution to a qualified plan: deferral of taxation of the contributed funds and investment returns thereon until the funds are withdrawn at retirement.
An individual retirement account is a trust or custodial account set up in the United States for the exclusive benefit of you or your beneficiaries. The account is created by a written document. The document must show that the account meets all of the following requirements. An IRA holder may have an unlimited number of IRAs with one or more financial organizations.
Who Can Set Up a Traditional IRA?
You can set up and make contributions to a traditional IRA if:
· You (or, if you file a joint return, your spouse) received taxable compensation during the year, and
·You were not age 70½ by the end of the year.
·You can generally set-up a Traditional IRA if you have income from working for yourself or someone else.
The Characteristics of a Traditional IRA
A Traditional IRA is generally a tax-deferred retirement savings account. Tax on Traditional IRAs is typically deferred IRA contributions until the year the IRA owner takes a distribution.
·Tax Deductible Contributions: The ability to take tax deductions for Traditional IRA contributions were designed to encourage savings for retirement.
Traditional IRA Contributions:
·$5,500 ( $6,500 if you’re age 50 or older), or
·your taxable compensation for the year.
When Can you Withdraw the Traditional IRA Funds?
You can withdraw your IRA assets at any time. However, as with distributions from other plans, a 10% additional tax, early distribution penalty, generally applies to IRA withdrawals before age 59½. Withdrawals of your own IRA contributions for a year before the due date for filing your return (to remove excess contributions, for example) are not subject to the 10% additional tax. Also, Roth IRA contributions (not including earnings) may generally be withdrawn without owing additional taxes
When are Traditional IRA distributions required?
You generally have to start taking withdrawals from your retirement plan or IRA once you reach age 70½ - often referred to as a required minimum distribution or RMD.
You cannot keep retirement funds in your account indefinitely. You generally have to start taking withdrawals from your IRA or retirement plan account when you reach age 70½. Roth IRAs do not require withdrawals until after the death of the owner.
·The minimum amount you must withdraw from your account each year is called your required minimum distribution.
·You can withdraw more than the minimum required amount. Your withdrawals will be included in your taxable income except for any part that was taxed before (your basis) or that can be received tax-free (such as qualified distributions from designated Roth accounts).
Calculating the required minimum distribution
The required minimum distribution for any year is the account balance as of the end of the immediately preceding calendar year divided by a distribution period from the IRS’s “Uniform Lifetime Table.” A separate table is used if the sole beneficiary is the owner’s spouse who is ten or more years younger than the owner.
Why Establish a Traditional IRA?
1. Cost Effective: A Traditional IRA can be established quickly and very cost effectively. The account can be opened at any local bank.
2. No Employer Required: A Traditional IRA can be established by any individual with earned income. Unlike a SEP IRA or Solo 401(k) Plan, the individual is not required to be a business owner or employee to participate.
3. Individual Controlled: With a Traditional IRA, the individual would generally have greater control over the retirement assets as a result of the assets being held in an IRA and not in a trust. The level of control the individual would have over the Traditional IRA assets would be based off the IRA custodian holding the assets and the type of available custodian approved investments.
4. Tax-Deferred Earnings: Earnings generated on Traditional IRA remain tax-deferred until distributed.
5. Tax Credit: Individuals who meet specific guidelines may be eligible to receive a tax credit (not to exceed $1000) for IRA contributions.
Disadvantages of Establishing a Traditional IRA vs. Other Retirement Plans
·Limitation of Annual Contributions: An Individual 401k would provide a larger contribution compared to a Traditional IRA at the same income level
·Loans are not permitted
·Minimal Retirement Planning Opportunities: Because of the low annual contribution limitation, using a Traditional IRA as the sole retirement vehicle could prove to be inadequate.