Traditional IRA

The first of all the modern retirement accounts in the United States, the “Traditional individual retirement account” or Traditional IRA has been around since at least 1986, when it was enacted under the Tax Reform Act of the same year.

The account is generally held by a financial institution regulated by the federal government, and the account holder can invest their IRA money in anything the institution allows. Some allow stocks and similar, others restrict deposits just to cash and certificates of deposit (CDs), still others even allow commodities or real estate to be invested.

The main eligibility metric to be allowed a Traditional IRA is that you have an income to generate money for deposits. However, financial institutions can build their own requirements on top of the income requirement (minimum initial deposit amount, records of identity and employment, etc.).

Why Invest in a Traditional IRA?

Taxes. They are charged on everything, except Traditional IRA deposits. Money placed in such an IRA account, especially pretax money, is not taxed until it is withdrawn. That means it can grow in the interim tax-free. This includes any interest earned, dividends paid, etc. However, when the money is withdraw or “distributed” then taxes are owed based on the income tax bracket at that time.

Due to the timing of this tax feature, the main allure of a Traditional IRA has been the scheduling of tax implications into the future. The expectation is that generally the account holder will be in retirement and earning less “earned” income (i.e. a paycheck from an employer) than right now. If true, then the same person will pay less on withdrawing the money at that time, then taxes paid right now if they took it from their gross paycheck immediately. Put another way, when earning the money your tax bracket could be as much as 28% of every earned dollar. In retirement it could be as low as 15%, so you pay less taxes for the same money.

This original concept of the Traditional IRA is the opposite of the Roth IRA, a later cousin in the U.S. retirement world. The Roth, in comparison, uses after-tax money and then allows your deposits to grow without taxes. When you withdraw there is no additional tax since you already paid up front prior to deposit. However, there is a general concern this rule may change in the future as the U.S. government continues with deficits and looks for new ways to tax, especially with the significant growth in Roth accounts since creation of the investment vehicle.

One added benefit of the Traditional IRA is the credit you get for having it, if you earn under a certain level of annual income. The Internal Revenue Service allows a tax deduction for deposits into a Traditional IRA. However, this benefit disappears if your income level is too high.