Back in the old days the standard career path was to get a job with a solid company, work for it for 40 years, then retire with a nice pension and go fishing. Fast forward to the real world. The average baby boomer held 11 different jobs before she reached her 45th birthday, according to the Bureau of Labor Statistics. A big part of your retirement planning falls on your own shoulders. A part of that plan could include contributing to a traditional individual retirement account, or IRA.
Congress authorized IRAs in 1974 to help taxpayers prepare for their own retirements by setting aside a portion of their earned income in a tax-advantaged account. You can fund your traditional IRA with pre-tax dollars. This means you can deduct the amount you contribute to your traditional IRA from your taxable income when you file your federal income tax return. The result is a lower current tax obligation, and more money in your retirement account.
A traditional IRA is a special type of trust or custodial account. You can only open an IRA with a financial entity that is approved by the Internal Revenue Service, such as a bank, federally-insured savings association or credit union, insurance company, mutual fund or investment brokerage. While your custodian can limit the types of investments to products that are available through its company, the IRS has few limitations on such investments beyond prohibiting investments in collectibles, such as artwork, antiques and gemstones. You must fund your traditional IRA with cash, but you can use the cash to invest in almost anything, including stocks, bonds, real estate, bank certificates of deposit and U.S.-minted gold and silver coins.
Tax Deferred Growth
Growth in your traditional IRA can include interest, dividends, capital gains, rents or royalties. Outside of a retirement account this growth would be fully taxable. But as long as the funds remain in your traditional IRA, the taxes on the growth of your investments are deferred. Your retirement dollars are not taxed until you withdraw them, usually after you reach retirement age when you will likely be in a lower tax bracket.
You can start taking qualified withdrawals from your traditional IRA once you reach age 59 1/2. You must start taking qualified withdrawals from your traditional IRA once you reach age 70 1/2. All qualified withdrawals from your traditional IRA are taxed as ordinary income in the year you receive them, regardless of how the funds arrived in your IRA.
All of the money in your traditional IRA belongs to you. You can withdraw all or any portion of it from your account at any time and for any reason. The Internal Revenue Service considers withdrawals made before you reach age 59 1/2 years to be non-qualified. These withdrawals are subject to taxation as ordinary income and you will be charged an additional tax penalty of 10 percent of the amount withdrawn.
- Internal Revenue Service: Publication 590, Who Can Open a Traditional IRA?
- Internal Revenue Service: Publication 590, Individual Retirement Account
- Internal Revenue Service: Publication 590, How Much Can You Deduct?
- Internal Revenue Service: Publication 590, When Can You Withdraw or Use Assets?
- Bureau of Labor Statistics: Number of Jobs Held (PDF)
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.