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What is an IRA

An Individual Retirement Account (IRA) is a tax-benefit account used to save money and invest in pensionable activities for retirement. The Internal Revenue Service (IRS) refers to the IRA in other general terms as Individual Retirement Agreements (IRA).

An IRA is a wide range of pension accounts, pensions and other trusts or custodial accounts acting as a personal savings plan, offering tax benefits for the placement of pension money. Within an IRA, you can grow your contribution tax free. This is the essential benefit that you can get when you have an IRA.

One of the most common types of IRA is the Traditional IRA, which we will discuss thoroughly below. Read through this page to help build your understanding before making any financial decision that will impact your retirement.

What is the Difference Between 401k and IRA?

A 401k is a pension scheme set up and administered by your employer. Comparatively, an IRA is a pension account opened by yourself, and its control lies with you.

You have restricted 401K investment options and will usually have a handful of investment plans to choose from. Contradictorily to this, an IRA offers you a wide array of IRA investments options, including equities, bonds, ETFs and mutual funds. IRA investments are chosen entirely for yourself. Some people opt to seek financial guidance from an independent financial advisor for their IRA.

You can own both a 401k and an IRA at the same time with separate contribution limits. If you have already maxed out on your 401k contributions, it can be an excellent supplement to your pension savings to make additional contributions to an IRA pension plan.

What is a Traditional IRA?

A Traditional IRA is one of the IRA types that allows you to defer taxation of your pension income. Once contributions are inside the IRA, your pension pot can grow free of tax, including capital gains tax from buying or selling investments. Only when you start making withdrawals will you be required to pay income tax on your pension income.

The tax advantage of the traditional IRA is one of its main benefits. Unlike a Roth IRA, which pays tax before making contributions and does not pay on withdrawals. Therefore, if you plan to have the same or lower tax bracket in the future, then the traditional IRA might be a sensible choice.

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How does a Traditional IRA work?

To open a traditional IRA, you must first be a US citizen or a qualifying non-US citizen if you live and work in the country. You can open a traditional IRA whether or not you are covered by other retirement plans such as 401k, the employer-based retirement plan.

With an enormous selection of investment options, the benefits of traditional IRA offers you full control over your assets. Some people perhaps find this overwhelming. That is why it is better to seek an independent financial adviser and get advice for your investments. With the right financial advice, investments are adjusted to suit your circumstances and risk attitude.

If you have a selection of investments already in mind, you can set up your traditional IRA yourself by using a broker of your choice. On the other hand, if you are inexperienced in investing and looking for a cheap solution, you could consider using a Robo-advisor.

A Robo-advisor will give automated financial advice based on algorithms that require minimum human supervision, keeping it low cost. In general, your investment management, risk profile and objectives will be examined and matched with the Robo-advisor's investment choice.

The last option, to receive the highest quality of financial advice, you must take the time to find an independent financial advisor that is regulated and well regarded in the industry, such as Cameron James.

Who Can Open a Traditional IRA?

Traditional IRAs are accessible by all US citizens. In most states, you can open an age as early as 18, 19 or 21 in others. If you are a young person who has started working but doesn’t have a 401k plan, it is important to open an IRA and begin saving. The earlier you start saving, the better positioned you are for retirement.

The IRS stated that the age limit for the traditional IRA contribution is the age of 70½. Therefore, beyond that age, all of your contributions will be repealed.

The Beneficiary Benefits Of a Traditional IRA

Apart from the tax benefit, the traditional IRA also includes a beneficiaries benefit. This means that, at the time of your death, your money saved in a traditional IRA will pass on to the designated person or entity of your choice. As well as choosing any individual, you can leave your IRA to organizations such as charities.

To read more about inheriting a Traditional IRA, read this article.

Can I Have a Traditional IRA if I Have another Retirement Plan?

You may have a traditional IRA and other retirement plans such as 401k at the same. However, IRA and 401K have separate contributions limits. By contributing to both a 401K and IRA plan, you may be eligible for tax deductions.

What are My Contribution Limits to Traditional IRA?

When you have finished setting up your traditional IRA, you can contribute to your traditional IRA via your trustee or administrator. All contributions should be in the form of money (cash, check, or money order). You are not allowed to contribute your properties.

The annual contribution limit for 2021 is capped at $6,000. However, if you are older than 50 years old, you can increase your contribution amount up to $7,000. Moreover, if you are less than 50 years old, your maximum contributions from the traditional IRA will be $6,000 regardless of how much your income is.

When Should I Withdraw My Traditional IRA?

Now the question is, will I be taxed when I withdraw my money before my retirement age? The short answer is yes. You will be taxed.

The IRAs are meant for long-term investment accounts for your retirement time and are subject to early withdrawal penalties, which means it is not a penalty-free product. You're liable to a 10% penalty, and you have to pay any later tax liabilities due when taking money out of an IRA before you're aged 59 1⁄2.

For instance, if you withdraw $10,000 with 25% tax from your traditional IRA before you are 59 1⁄2 years old, you will be taxed an extra 10% as IRA early withdrawal penalties. That means you will have $10,000-25%($2,500)-10%($1,000), which will leave you $6,500.

Traditional IRA Contribution Deduction

Traditional IRA is deductible contributions IRA or IRA contributions can be deducted from your taxable income fully or partially drawn from your income, which will benefit you in terms of lowering your tax obligations. Three factors influence your traditional IRA contribution deduction, those are: your filing status, the ownership of an employer-sponsored retirement plan, and your modified adjusted gross income or known as MAGI.

MAGI calculation is from adjusted gross income or AGI. AGI is your yearly gross revenue less specific adjustments used for determining your income tax obligations for the year by the Internal Revenue Service. Your MAGI determines the deduction of your traditional IRA contribution. Apart from that, your MAGI also determines whether or not you may enroll in Roth IRA, earning income tax credit or education tax credit, and subsidized health insurance program.

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The table below presents the eligibility for traditional IRA contribution deduction. You may follow this table as a guideline for your considerations.

Filing Status Your MAGI What You Get
single or head of household $66,000 or less a full deduction up to the amount of your contribution limit.
more than $66,000 but less than $76,000 a partial deduction.
$76,000 or more no deduction.
married filing jointly or qualifying widow(er) $105,000 or less a full deduction up to the amount of your contribution limit.
more than $105,000 but less than $125,000 a partial deduction.
$125,000 or more no deduction.
married filing separately less than $10,000 a partial deduction.
$10,000 or more no deduction.

Excess IRA Contribution Tax

The IRS stated that there is the possibility of an excess tax to occur to your traditional IRA if three of these things below happen:

  • You have more contribution than your contribution limit
  • You contribute to your traditional IRA when you are aged 70½ and older
  • You create incorrect IRA rollover contributions

For each year, the surplus contribution remains taxed at 6% per year in the IRA. At the end of the tax year, the excess tax may not exceed 6% of the total value of all your IRAs.

In order to avoid the 6% tax excess, you must withdraw from your IRA the surplus taxes (including the extensions) and any revenues derived from the excess contribution by the due date of your individual tax return. Nevertheless, the IRS has specific requirements to ensure that extra payments are not withdrawn from your gross income.

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Distributions from Traditional IRA

In general, you can withdraw money from your traditional IRA at any time after your retirement age. However, as discussed above, there will be penalties if you withdraw your traditional IRA early before you are aged 59 1⁄2.

You can withdraw from a traditional IRA by filing Form 1040 with the amount of your desired withdrawal on the form. The IRS has a rule of minimum distribution when you are reaching a certain age. The rule is called the Required Minimum Distributions (RMD). The RMD obliges you to withdraw a minimum amount of distributions from your traditional IRA because you cannot keep your money within your traditional IRA indefinitely.

Typically, you have to start withdrawing money from your traditional IRA account in a minimum amount year-on-year when you reach the age of 70½. However, you can withdraw more than the minimum amount of your RMD each year. Each withdrawal of your RMD is treated as income tax payable. The RMD will take place every 1 April of the calendar year in which you reach the age 70½.

The RMD retirement plan applies to every type that is listed below:

  • Traditional IRAs
  • SEP IRAs
  • 401(k) plans
  • 403(b) plans
  • 457(b) plans
  • Profit-sharing plans
  • other defined contribution plans

Calculating RMD

Commonly, the calculation of the RMD (Required Minimum Distributions) is your current account balance (as of the end of the prior calendar year) divided by the distribution term from the Uniform Lifetime Table of the IRS.

There are some tables available as a tool to guide you in calculating your RMD, which the IRS provides. Those tables are as follows:

  • The Uniform Lifetime Table: For single traditional IRA holders, married holders whose spouses are not more than ten years younger, and married traditional IRA holders whose spouses are not the only beneficiaries of the traditional IRA.
  • Table Single Life Expectancy: This table is used for beneficiaries of the traditional IRA who are not the spouse of the holders.
  • Table Joint Life and Last Survivor Expectancy: Table for traditional IRA holders who are married and their spouses are the only beneficiaries of their traditional IRA.

What Happens if I did not Take My RMD?

In any case that you are not withdrawing or generally taking your RMD on your traditional IRA when you are reaching age 70½, there is a consequence that you have to bear. According to the IRS, you will have to pay the 50% excise tax on the amount of the undistributed traditional IRA.

Reporting the excise tax, you can use Form 5329, or if you would like to learn more about the tax, you can click here.

Who Will Pay My RMD When I Die?

In the event of your death, your RMD will descend to your designated beneficiaries (spouse, son, or daughter). To calculate the RMD, you can use the Single-Life Expectancy table and Joint Life and Last Survivor Expectancy table above, which the IRS provides.

The life expectancy variable, which is inside the table, divides the account balance amount to calculate the first RMD after your time of death. Furthermore, for the subsequent year, the life expectancy is lowered by one.

Is Traditional IRA the Best Retirement Plan for Me?

There are types of IRAs available for you to choose to invest in for your retirement time. However, the decision to choose a retirement plan should not be taken lightly. Even though you can manage your own IRA, it is best that you seek financial advice from Cameron James to truly understand your circumstances and which IRA is suited best for you.

Our independent financial advisor will be happy to assist you in choosing the right retirement plan. Initial consultation with Cameron James is always given at no cost.

About Dominic Murray

My career in financial services began in 2010 during my Bachelor of Science (BSc) Undergraduate degree at Aston University in England. The degree required me to spend a year abroad working with an established organisation.

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