What is a traditional IRA? Here’s how using one can save thousands on your taxes

A traditional IRA offers tax-deferred growth, allowing your investments to grow faster than they would in a taxable brokerage account. You can often deduct your contribution from your taxable income, leaving you with more money for your other financial goals.

What is a traditional IRA?

A traditional IRA is an individual retirement account that offers tax-deferred growth and often the ability to deduct your contributions from your taxable income. It can be a powerful way to defer taxes until retirement, when you may be in a lower tax bracket than in your working years.

If you’re a DIY investor, opening a traditional IRA with a brokerage company allows you to choose from a wide range of stocks, bonds, mutual funds, ETFs, and other investment options to build the portfolio of your choice. Most robo-advisors also offer traditional IRAs and pre-built portfolios that make investing as easy as set-it-and-forget-it. Or, if you’d like to take a more conservative approach, an IRA CD combines the safety and predictability of a CD with the tax advantages of an IRA.

One of the best features of a traditional IRA is that it’s accessible to anyone with earned income. You may or may not be able to deduct your contribution (more on that below), but no matter how much you make you can contribute and take advantage of the tax-deferred growth it offers.

How does a traditional IRA work?

The primary benefit of a traditional IRA is the ability to deduct contributions and defer taxes on your investment growth until retirement.

For 2023, you can contribute up to $6,500 to your traditional IRA or up to the amount of earned income, whichever is less. If you are age 50 or above, the annual limit is $7,500. As long as you fall below the income thresholds detailed below, every dollar you contribute is subtracted from your taxable income.

For example, if your taxable income would otherwise be $75,000 and you contribute $6,500 to a traditional IRA, you would only be taxed on $68,500. Assuming you’re in the 22% tax bracket, that would save you $1,430 in taxes, money that could then be put towards other goals or needs.

On top of that, your investments grow tax-deferred as long as the money is inside your traditional IRA. That saves you from paying taxes on dividends and capital gains each year, which means you can harness the power of compound interest.

“Without tax deferral, you’ll have to pay some manner of tax on the investment growth each year,” says Brian McGraw, CPWA, CFP, Senior Wealth Advisor with Hightower Wealth Advisors in St. Louis, MO. “The deferral allows you to push that tax off into the future, which means you may be able to keep more pennies out of every dollar when you go to pull that money out.”

There are some downsides to traditional IRAs, however. If you’re participating in a 401(k) or other employer plan, you may be unable to deduct your contributions if your income exceeds the IRS limits. Details on those limits are below.

Your withdrawals will be taxed as ordinary income in retirement. This isn’t necessarily a bad thing, especially if you’re in a lower tax bracket in retirement than you were during your working years. But it is a reality you will have to navigate.

While you can access your money at any time, withdrawals made before age 59.5 will be subject to a 10% early withdrawal penalty in addition to ordinary income tax. There are some exceptions, however, such as using the money for qualified education expenses or withdrawing up to $10,000 for a first home purchase.

Traditional IRAs are also subject to required minimum distributions (RMDs). Once you reach age 73 (or age 72 if you turned 72 before December 31, 2022), the IRS requires you to withdraw a certain amount of money from your traditional IRA each year. This amount is determined based on your age and your account balance.

“It could be quite a bit that you have to distribute later in life, which could put you into a much higher tax bracket while you’re in retirement,” says Cait Howerton, MBA, CFP®, a financial planner with Archer Investment Management in Atlanta, GA. “So there are some benefits to not only having pre-tax money in retirement but also having taxable money and Roth money.”

Who can open a traditional IRA?

Anyone with earned income can open and contribute to a traditional IRA. There are no income limits on contributions. Those limits, which are explained in detail below, only apply to the ability to deduct contributions.

This can be incredibly valuable for anyone who doesn’t have a 401(k), or anyone who simply wants to maximize their retirement savings.

“If you don’t have access to a 401(k), a traditional IRA is one way that you can get ahead and save some money and reduce your taxable income at least by $6,500,” says Howerton. “Or if you have the cash flow to do so, you can max out your 401(k) and take advantage of traditional IRA contributions alongside that.”

What is a nondeductible IRA?

If you participate in an employer plan and your income exceeds the IRS limits (see below for details), you may not be able to deduct your traditional IRA contributions. In that case, any contributions to a traditional IRA would be considered nondeductible contributions.

With a nondeductible IRA, your contributions do not reduce your taxable income but you still benefit from tax-deferred growth. When you withdraw money in retirement, your contributions are not taxed but your earnings are taxed as regular income. Nondeductible contributions are tracked using Form 8606 on your tax return.

Nondeductible IRAs are often used as a vehicle for people who make too much for regular Roth IRA contributions to get money into a Roth account by utilizing a Backdoor Roth IRA. With this strategy, you first make a nondeductible IRA contribution and then quickly convert it to a Roth IRA, after which your money grows tax-free.

“That is probably the most common usage with our clients where we would recommend making a nondeductible IRA contribution,” says McGraw. “Otherwise, if you’re making nondeductible contributions and keeping them in there and mixing them with traditional contributions, it gets complicated to be able to separate how each dollar within the IRA is taxed.”

Traditional IRA contributions limits 2023

For 2023, you can contribute a maximum of $6,500 to a traditional IRA. If you are age 50 or older, the contribution limit is $7,500.

There are no income limits on contributions. Anyone with earned income can contribute, no matter how much they make. And if neither you nor your spouse participate in an employer retirement plan, you can deduct your contribution no matter how much you make.

However, if either you or your spouse does participate in an employer retirement plan, there are income limits that may prevent you from deducting your contribution. Those limits depend on your tax filing status and whether it is you or your spouse who has an employer plan.

The following limits apply for 2023 if you participate in an employer retirement plan:

If you do not participate in an employer retirement plan but your spouse does, the following limits apply for 2023:

Traditional IRA pros and cons

Traditional IRAs allow anyone with earned income to take advantage of tax-deferred investment growth, but there are some downsides to consider as well.

Pros

• Anyone can contribute. If you have earned income, you can contribute to a Traditional IRA.
• Deductible contributions. Contributions reduce your taxable income, provided you fall within the income limits detailed above.
• Tax-deferred growth. Your money grows tax-deferred while inside the traditional IRA.
• Wide range of investment options. You can choose from a wide range of stocks, bonds, mutual funds, ETFs, and other investments to build the portfolio you want.
• Flexible contribution timing. You have until the tax filing deadline of the following year to make your contribution.

Cons

• Income limits on deduction. If you participate in an employer retirement plan, you may not be able to deduct your traditional IRA contributions.
• Taxable distributions. Distributions in retirement are taxed as ordinary income.
• Required minimum distributions. Depending on when you were born, you will be required to take minimum annual distributions from your traditional IRA once you reach age 72 or 73.
• Early withdrawal penalty. If you withdraw money before age 59.5 and it isn’t an allowable exception, there is a 10% penalty in addition to ordinary income tax.
• Low contribution limit. Compared to a 401(k), the amount you’re allowed to contribute each year is relatively low.

The takeaway

Traditional IRAs ensure that everyone, no matter how much you make or what your employer offers, can save for retirement in a tax-advantaged manner.

“For high-income earners that are already getting hit pretty hard on taxes, a traditional IRA allows you to save money and reduce some of that tax hit,” says McGraw. “But even for non-high-earning professionals that are trying to save and still pay the bills and support their families, having that ability to lower their taxable income can be an attractive way to save for retirement.”

No matter your situation, a traditional IRA can help you both save for the future and save money today.