Traditional IRA: The Tax Break Today
Unlike the Roth IRA (which saves taxes later), the Traditional IRA gives you a tax deduction right now. If you contribute $7,000 and are in the 22% bracket, you save $1,540 on this year's tax bill.
Deductibility Limits
Not everyone can deduct their contribution. If you (or your spouse) have a workplace retirement plan (like a 401k), the deduction phases out at higher incomes (~$77k Single, ~$123k Married). If you don't have a workplace plan, it's fully deductible regardless of income.
The Pro-Rata Rule Warning
If you have money in a Traditional IRA (pre-tax) and try to do a Backdoor Roth conversion with new money, the IRS taxes you proportionally. You cannot just convert the "new" money.
- Example: You have $93,000 in old IRA. You add $7,000 new. You convert $7,000.
- Result: 93% of that conversion is taxable. Only 7% is tax-free. This surprises many people with big tax bills.
Required Minimum Distributions (RMDs)
The government wants its tax money eventually. With a Traditional IRA, you MUST start withdrawing money at age 73 (or 75). These withdrawals are taxed as ordinary income. If you don't withdraw, the penalty is 25% of the amount you failed to take.
Spousal IRA
Usually, you need earned income to contribute. However, a non-working spouse can open a "Spousal IRA" based on the working spouse's income. This allows a couple to save $14,000/year (2 x $7,000) even if only one person works.
Strategic Roth Conversion
A smart strategy is to contribute to Traditional IRA during high-earning years (save 32% tax), then convert to Roth in a low-earning year (e.g., sabbatical, early retirement) when your bracket is only 10% or 12%.
SEP IRA and SIMPLE IRA
If you are self-employed, a Traditional IRA ($7,000 limit) is too small. You should look at:
- SEP IRA: Contribute up to 25% of your profit (max $69k).
- SIMPLE IRA: Easier to set up for small businesses with employees.
FAQs
- Can I contribute to both Tradition and Roth?
- Yes, but the $7,000 limit applies to the total. You can do $3.5k in each, but not $7k in each.
- Can I borrow from my IRA?
- No. Unlike a 401(k), you cannot take a loan from an IRA. Any withdrawal is permanent and taxable (plus penalty if under 59.5). There is a "60-day rollover" rule, but it is risky.
- Is there an age limit for contributions?
- No. As long as you have "Earned Income" (wages), you can contribute at age 80.
- What if I contribute too much?
- You must withdraw the excess before tax day, or pay a 6% penalty every single year it stays in the account.