Traditional IRA is an IRA that front-loads the tax benefits of using an IRA. Those benefits are:
- Contributions to a Traditional IRA are frequently deductible against income taxes
- Profits in a Traditional IRA accrue tax-free while remaining inside the IRA
When the very last Studebaker rolled off the production line in the early 1960’s, nobody realized that the impending failure of the once-iconic auto manufacturer would result in the creation of the Traditional IRA, one of the most powerful financial tools ever provided to Americans.
The Traditional IRA was intended to "decouple" retirement savings from one's employer...
The fall of Studebaker – or more precisely, the implosion of their pension plan – resulted in thousands of employees having no means of support during retirement, despite promises to the contrary from Studebaker. Though they didn’t know it in advance, the pensions of these employees was tied to the fate of the business itself…
…When the business failed, so did the pension.
As more and more life-altering pension implosions happened with the failure of other businesses in the 1950’s, 60’s and 70’s, Congress responded with the creation of a new law – the Employee Retirement Income Security Act of 1974 (ERISA) – which, among other things, resulted in the creation of a totally new type of financial account: the Individual Retirement Arrangement.
This is the account we now refer to as the “Traditional IRA”.
The objective of the IRA was to make retirement savings an individual matter rather than a corporate matter, as employers were all too frequently showing improper regard for their pension commitments.
By giving individuals the ability to save and invest for their own retirement wholly separate from their employers, the US government was providing a substantial degree of insulation against the risk of future pension failures.
The Traditional IRA had some features that were rather innovative for the time:
- The account eliminated pension failure risk because it was connected only to a person and not to an employer
- Americans would be incentivized to contribute to their IRA's and remain invested through aggressive tax benefits
- The account would have special protections against creditors and bankruptcy
- There would be almost no limitations whatsoever on the types of investments that could be made in an IRA
Why Use A Traditional IRA?
Using a Traditional IRA for retirement savings involves 5 primary benefits:
- Income tax deferral for contributions to the plan
- Income tax deferral for profits made in the plan
- Nearly unrestricted choice of asset type (stocks, real estate, precious metals, etc.)
- Protection against many types of creditor actions including bankruptcy
- Very simple bequeathing to future generations
I'll break down each of these benefits in much greater detail for you, but...
In a nutshell, the Traditional IRA enables you to make deposits into an IRA and receive an income tax deduction for that deposit. You may also invest and re-invest that money into virtually any type of asset, and the profits from those investments accrue tax-free…
…Indeed, under practically all circumstances, there’s no tax liability at all with Traditional IRA’s until you begin making withdrawals. Those withdrawals will be taxed as regular income.
A Serious Tax DISADVANTAGE For The Traditional IRA?
If you’re shrewd, you may have noticed that last sentence: Those withdrawals will be taxed as regular income. And if you’re really shrewd, you’ll recognize that this means there’s a high degree of unpredictability if you use a Traditional IRA.
Where is the unpredictability? It comes in two forms:
- What if income tax rates rise, and the rate you’re paying during retirement is higher than the rate you paid during your working years?
- What if you are very successful in your IRA, yielding a balance many times your original investment? Even a slow withdrawal of your IRA balance could put you in a higher tax bracket
But there’s more…
…One of the unfortunate features of the Traditional IRA is that your withdrawals are not taxed as investment profits, they’re taxed as if they’re wages from a job. The problem is that taxes on investment profits (called “Capital Gains”) are almost always cheaper than taxes on wages from a job (income taxes).
As of right now, in fact, capital gains rates are generally 15-20%. Income taxes, on the other hand, go as high as 39.6% at the federal level alone.
In effect, the Traditional IRA forces you to pay taxes at a potentially much higher rate than you’d pay if you’d done the same investment outside of the IRA.
The real point is that you just don’t know. It’s totally unpredictable…
- Is it possible that you’ll be in a lower income tax bracket during retirement, and thus pay a lower real tax rate by using the Traditional IRA? Yes, it’s possible. But…
- Is it also possible that you’ll be in a higher income tax bracket during retirement, and thus pay a higher real tax rate by using the Traditional IRA? Yes, it’s possible. But…
- Is it possible that you could pay a much lower overall tax rate by making an investment outside of an IRA rather than inside, and thus pay capital gains taxes instead of income taxes? Yes, it’s possible. But…
…You just don’t know and can’t really predict. And it’s that unpredictability that’s the biggest disadvantage of the Traditional IRA.
(Many of these disadvantages are overcome by using the Roth IRA, at the expense of receiving tax deductions for your contributions.)
Who is Eligible To Contribute To A Traditional IRA?
Traditional IRA eligibility requirements are very simple. If you:
- Have “earned income” – such as wages from a job; and
- You are 70 ½ or younger, then…
…you’re eligible to contribute to a Traditional IRA.
Note that your eligibility to contribute to a Traditional IRA can change fro year to year. For example - assuming you're younger than 70 1/2 - you would be eligible to contribute in year 1 when you earn income from a job, but in year 2 if all of your income comes from passive sources (like rental income), you'll not be eligible to contribute to your IRA for year 2. If you again begin receiving earned income in year 3, you can again make contributions to an IRA for that year.
Minimum and Maximum Contribution Limits
For tax year 2017, the maximum contribution for a Traditional IRA is $5,500, unless you’re 50 or older, in which case the maximum is increased to $6,500.
There is never a minimum contribution imposed by law for your Traditional IRA, though it’s possible your account custodian could impose additional constraints.
Warning: Your Traditional IRA Contributions Aren’t Automatically Deductible
In typical fashion for tax rules, you can’t simply assume that you’re entitled to taking a deduction for contributions to a Traditional IRA.
In addition to qualifying to contribute by earning income and being under age 70 ½, a couple of other factors come into play in determining whether – and how much of – your contributions can be deducted against your income taxes:
- Your income
- Your income tax filing status
- Whether you or a spouse are covered by a retirement plan at work
Here are the latest rules, courtesy of our friends at the IRS:
Rules For Investing Through A Traditional IRA
One of the most common misconceptions about IRA’s in general is that an IRA is itself an investment. “Investing in an IRA” has no meaning by itself because an IRA is just an account, like a saving account or a stock brokerage account.
Here’s how the process of using an IRA works:
- First you deposit money into the IRA
- Then you invest the money held in your IRA
- Then you withdraw you deposits and investment profits from your IRA
An IRA is just an account to hold investments, but is not itself an investment.
That being the case, the right question to ask is: What kinds of investments am I allowed to make with the money I deposit into my IRA?
Surprisingly, the answer is simple, at least conceptually:
- Your IRA can’t buy life insurance or collectibles
- Your IRA can’t invest in precious metals, with a few big exceptions
- Your IRA can’t engage in a handful of prohibited transactions (such as lending money to YOU)
- Your IRA can’t do anything which benefits any “disqualified persons”
Let's take a closer look at each of these few restrictions fro your IRA...
Avoid Prohibited Assets
Under federal law, there are only two asset types that are specifically prohibited for purchase in a Traditional IRA:
- Life insurance
It's generally pretty simple to recognize life insurance when you see it, but the term "collectibles" is far more vague. The IRS has provided this list to "clarify" the definition of collectibles:
- Metals - with exceptions for certain kinds of bullion,
- Coins - (but there are exceptions for certain coins),
- Alcoholic beverages, and
- Certain other tangible personal property
(Did you notice that last item on the list? "Certain other tangible personal property." That sounds like a loophole the IRS has left for themselves to define more things as collectibles in the future, so be careful here. If you have any question whether a particular asset qualifies as a collectible - and is thus disqualified in your IRA - consult an experienced IRA attorney. I recommend Tim Berry.)
The bigger point is that there are only two asset-type prohibitions for your IRA: life insurance and collectibles.
I’ve heard my IRA can’t buy S-Corporation stock. Is this true?
This is technically untrue, but is grounded in truth.
The law that created IRA’s – ERISA – stipulated only Life Insurance and Collectibles as prohibited assets. As far as ERISA is concerned, everything else is on the table.
But there’s another law to consider, called 26 U.S. Code § 1361, which created a new taxation scheme for corporations called the “S” election. Designed for small businesses with a low number of shareholders, this taxation structure can be very beneficial for some businesses.
Unfortunately, §1361 clearly established a limited group of people and entities who are eligible to own shares of a corporation that has elected “S” treatment. Also unfortunately, IRA’s aren’t on that list.
However, that does not mean that S-Corporations are prohibited in IRA’s like insurance and collectibles. An S-corporation is just a corporation, and corporations are totally kosher for IRA’s.
But there are penalties imposed by §1361 if an ineligible party – such as your IRA – becomes owner of shares in an S-Corporation. The penalty is that the corporation immediately loses its “S” tax status, which can cause tremendously negative tax consequences for the corporation itself and any others who own shares in that corporation.
So technically, S-Corporations are not prohibited assets and can be owned in an IRA. But practically, buying an S-corporation with IRA funds causes the corporation not to be an S-corporation any longer.