Traditional IRA

A Traditional IRA is a savings plan that allows you to set aside money for retirement. In the case of a traditional IRA, you may also be offered an immediate tax shelter for the contributions that you make to your account.

In this article we're going to discuss many of the different rules you'll encounter with traditional IRAs.  That discussion will include eligibility, contributions, income limits, as well as withdrawals from these accounts.

Traditional IRA Eligibility Rules

In order to make a contribution to a traditional IRA, you only need to pass two tests or rules.  The first has to do with age.  You must be under the age of 70 1/2 at the end of the calendar year.  After age 70 1/2, you're no longer eligible to contribute to a traditional IRA.

The second eligibility test has to do with compensation.  In order to contribute to a traditional IRA, you must have some form of compensation.  Compensation includes wages, salaries, bonuses, and commissions.  Compensation does not include deferred compensation, or payments such as interest income and stock dividends that you might have received during the year.

IRA Income and Compensation Limits

Now that we know who can make a contribution to a traditional IRA, it's time to discuss how much they can contribute.  In this first section, we are going to talk about income limitations for making a tax-deductible contribution, which involves rules that have been established by the IRS. 

Tax-deductible traditional IRA contributions are subject to an income phase-out rule.  This means that starting at a certain level of modified adjusted gross income, or AGI, your ability to take a tax deduction is phased-out.

There is an important twist to this rule that is important to understand.  If you or your spouse is covered by a qualified retirement plan at work, then the phase-out for the deduction takes place at a lower level of income.  If you are not sure if you are covered by a qualified retirement plan, then there is a very easy way to find out.  Take a look at your W-2, and there is a "Retirement Plan" box.  If this box is checked, then you were covered by a qualified plan.

Now that we know there are two sets of rules for taking a tax deduction for a traditional IRA, here are the four tables showing all the income limits for 2011 and 2012:

2011 Traditional IRA AGI Deduction Limits
(If Covered by a Retirement Plan at Work)

2012 Traditional IRA AGI Deduction Limits
(If Covered by a Retirement Plan at Work)

2011 Traditional IRA AGI Deduction Limits
(If NOT Covered by a Retirement Plan at Work)

2012 Traditional IRA AGI Deduction Limits
(If NOT Covered by a Retirement Plan at Work)

IRA Contribution Limits

Now we have the complete eligibility picture for a traditional IRA, the basics of participation, and the limits of participation.  In this next section, we're going to answer the question of maximum contributions.  We're going to start with some of the general rules that apply to everyone, and then work our way to the more detailed and complex contribution rules and limits.

The table below displays the contribution limits for 2007 through 2012, including catch-up contributions.  Regardless of whether or not these contributions are tax deductible, these are the limits, with one exception.  You cannot contribute more to a traditional IRA than your compensation for the calendar year.  For example, if you earned $2,500 in compensation for the year, then you can only contribute $2,500 to a traditional IRA even though the limit for 2012 is $5,000.

The same rule applies if you file a joint return.  If your total compensation (you plus your spouse) is $5,000, then the total of all your IRA contributions (including a Roth IRA) cannot exceed $5,000.  Subject to the compensation limitations that were previously explained, those filing a joint return can make two contributions to a traditional IRA, one for each spouse. 

IRA Contribution and Catch-Up Limits

Note:  The catch-up limit applies to individuals that have reached the age of 50 or older.  In 2013 and beyond, these limits will be indexed for inflation.  Standard contributions can move up in $1,000 increments, while the catch-up contributions can move up in $500 increments in future years.

We discuss this topic in more detail in our article on IRA Contribution Limits.

IRA Distributions and Withdrawals

You can take a qualified distribution, or withdrawal, from an IRA after age 59 1/2.  Before age 59 1/2, removing money from your IRA is considered an early withdrawal.  Unless you qualify for an exception, which is discussed in our article on IRA Withdrawals, then taking an early withdrawal from your IRA means you are subject to an additional 10% tax penalty.

This 10% penalty is in addition to any federal income tax due on the amounts distributed.  That would include any money put into your IRA account on a tax-deferred basis, since traditional IRAs also allow for contributions on an after-tax basis (non-deductible contributions).

Minimum Required Distributions

Starting at age 70 1/2, traditional IRAs also have minimum required distributions.  This is money that the IRS expects you to remove from your account each year starting at age 70 1/2.  This topic has been covered more thoroughly in our article on Minimum Required Distributions.  We've also prepared a Minimum Required Distribution Calculator to help you estimate these withdrawals. 

If you do not take your minimum required distribution from your traditional IRA, then the amounts not withdrawn are subject to an additional 50% tax penalty.

IRA Rollovers

An IRA Rollover is defined as a tax-free distribution taken from one retirement account that is contributed to an IRA.  There are several different kinds of retirement accounts that can be rolled-over into a traditional IRA, including another traditional IRA, an employer's qualified plan such as a 401(k) plan, deferred compensation plans (section 457 plan), and a tax-sheltered annuity plan such as a 403(b).

Transferring IRA Money

There are two ways of moving IRA funds between financial institutions: performing a transfer or doing a rollover.  In most cases, it is far easier to do a transfer than a rollover.

• IRA Direct Transfers:  with a transfer, you would make arrangements with a financial institution to receive funds from your current institution.  The receiving institution then sends a request to the disbursing institution, requesting a transfer of IRA funds.
• IRA Rollovers:  with a rollover, the retirement funds are distributed from the disbursing institution directly to the former account holder.  This means a check is sent directly to an individual, not another institution.

Direct transfers do not have to be reported to the IRS; however, rollovers need to be reported.  This reporting of a rollover ensures the individual receiving this money abides by the rollover rules, and deposits the money into another qualifying retirement account in a timely manner.  Rollovers are also subject to 20% withholding, which is discussed in more detail in our article on IRA Rollovers.

Traditional versus Roth IRA

If you cannot make a tax-deductible contribution to a traditional IRA, then you always have the option of making a contribution that is not tax deductible.  Before doing so, make sure you have explored the option of contributing to a Roth IRA.

For some taxpayers, a traditional IRA allows you to take an immediate deduction from your taxes as discussed above.  This provides the taxpayer with immediate tax relief.  However, when making a withdrawal from a traditional IRA, all of the money that was never subject to federal taxes becomes taxable at withdrawal.

With a Roth IRA, you cannot take an immediate tax deduction for any of the amounts placed into the account.  However, all money withdrawn from a Roth IRA is not subject to federal taxes.  This means you can realize a capital gain, or interest income, and not have to pay any taxes on these gains.

IRA Calculators

We're going to close this publication with a quick mention of our online calculators.  We offer a complete line of retirement calculators, including those that can help you model your retirement income, funding, and even help you to choose between a Roth and a Traditional IRA.

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