Traditional IRA

A Traditional IRA is a tax-deferred retirement savings account. You pay taxes on your money only when you make withdrawals from this account. Deferring taxes means all of the dividends, interest payments and capital gains that accumulate in a Traditional IRA can compound each year without being hindered by taxes - allowing your IRA to grow much faster than a taxable account.

Traditional IRAs come in two varieties: deductible and non-deductible. Whether you qualify for a full or partial tax deduction depends primarily on your income and whether you have access to a work-related retirement account like a 401(k).

Contribution Limits

The contribution limit to your Traditional IRA for 2009 and 2010 is the smaller of the following amounts:

• $5,000, or
• Your taxable compensation for the year.

If you were age 50 or older before 2010, the most that can be contributed to your Traditional IRA for 2009 (and age 50 or older before 2011 for 2010) is the smaller of the following amounts:

• $6,000, or
• Your taxable compensation for the year.

Contributions can be made to your Traditional IRA for each year that you receive compensation and have not reached age 70½. For any year in which you do not work, contributions cannot be made to your IRA unless you receive alimony, nontaxable combat pay or file a joint return with a spouse who has compensation. Even if contributions cannot be made for the current year, the amounts contributed for years in which you did qualify can remain in your IRA. Contributions can resume for any years that you qualify.

Contributions can be made to your Traditional IRA for a year at any time during the year or by the due date for filing your return for that year, not including extensions. For most people, this means that contributions for 2009 must be made by April 15, 2010, and contributions for 2010 must be made by April 15, 2011

Advantages

• The main advantage of a Traditional IRA, compared to a Roth IRA, 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 bracket, then a $1,000 benefit ($1,000 reduced tax liability) will be realized for the year. Because qualified distributions are taxed as ordinary income (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.
• 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.
• With a Traditional IRA is that the taxpayer gets the tax benefit immediately

Disadvantages

• There are the eligibility requirements for the tax-deductibility. 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 income, a Roth IRA in effect shelters more assets from taxes on gains than a Traditional IRA does. Suppose someone with $4000 to invest is eligible to either contribute $4000 to a Roth IRA, or to contribute $4000 to a Traditional IRA and deduct it. If one chooses the Traditional IRA, then one receives an upfront tax deduction (worth, say, $1000 to someone in the 25% tax bracket). When the money is withdrawn from the Traditional IRA it will be taxed at marginal rates. On the other hand, if one chooses the Roth IRA, then there is no upfront tax deduction, but the money and the gains are all exempt from taxes upon retirement. So, someone must be in a lower tax bracket upon retirement than in their contribution year for a Traditional IRA to be tax preferential to a Roth IRA.
• Perhaps the greatest disadvantage of the Traditional IRA is its forced distributions based on age. Withdrawals must begin at age 70½ (more precisely, 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

Eligibility

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 have a Traditional IRA whether or not you are covered by any other retirement plan. However, you may not be able to deduct all of your contributions if you or your spouse is covered by an employer retirement plan.

If both you and your spouse have compensation and are under age 70½, each of you can set up an IRA. However, you cannot both participate in the same IRA. If you file a joint return, only one of you needs to have compensation.

Distributions

You can withdraw or use your Traditional IRA assets at any time. However, a 10% additional tax generally applies if you withdraw or use IRA assets before you are age 59½.

You generally can make a tax-free withdrawal of contributions if you do it before the due date for filing your tax return for the year in which you made them. This means that, even if you are under age 59½, the 10% additional tax may not apply.

You cannot keep funds in a Traditional IRA indefinitely. Eventually the money they must be distributed. If there are no distributions, or if the distributions are not large enough, you may have to pay a 50% excise tax on the amount not distributed as required. The requirements for distributing IRA funds differ, depending on whether you are the IRA owner or the beneficiary of a decedent's IRA

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