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The Ever Unpopular Traditional IRAs

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Ever notice that tons of personal finance sites talk about Roth IRAs all the time but rarely talk about Traditional IRAs? I think part of the reason is that the Roth IRA is newer so there’s far less literature on it and because it’s sexier – forty years of tax free appreciation and then no tax on disbursement? That’s pretty hot. The downside is that some people can’t contribute to the Roth so they’re stuck with the Traditional route, something that isn’t discussed as much.

About Traditional IRAs

The Traditional IRA is much like the Roth IRA except contributions are tax deductible unless your employer offers a retirement plan. This means you get tax savings immediately since your income will be reduced by the amount of your contribution. It’s very much like a 401k from a tax perspective, which explains why the deductibility rules are structured the way they are. If your employer offers a 401k, Keogh, SEP-IRA, etc; then the deduction is limited. The rules are a little complicated so I direct you to a past article I wrote about IRS income phaseouts (specifically IRA contributions) with respect to contribution limits and deductibility.

From there, the Traditional IRA grows tax free much like a Roth IRA. However, whenever you start taking disbursements, those earnings are then taxed at your marginal tax rate. You are also required to take minimum disbursements once you hit the age of 70½, which is something you are not required to do with a Roth IRA. If you don’t take the required minimum distributions then you will be penalized (you will always want to take these distributions).

Finally one last distinction worth noting with respect to Traditional and Roth IRAs; if you make an early withdrawal on your Traditional IRA, you will have to pay taxes plus a 10% penalty. With a Roth, you can withdraw them contributions at anytime (since you’ve already paid taxes on it).

So, why a Traditional IRA and not a Roth? There are two reasons:

  • Income restrictions. If you have too much income, you will be prohibited from contributing to a Roth IRA, this is the main reason why folks choose Traditional over Roth (or rather they settle, because they never had the choice).
  • Tax law concerns. The government can always decide to tax Roth IRA disbursements, which means you’d be doubly taxed. This is less of a concern but still one that bears mentioning since it could always happen.

Traditional IRA Conversion

Another considering for those thinking about Traditional IRAs is that if you have a modified adjusted gross income in excess of $100,000, you currently cannot convert your Traditional IRA to a Roth IRA. However, in 2010 and 2011, that prohibition will be lifted so anyone can do the conversion. When you convert all or part of your Traditional IRA, you pay taxes immediately on the funds converted if you haven’t done so already.

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10 Responses to “The Ever Unpopular Traditional IRAs”

  1. JohnnyB says:

    Is that all the choices someone has? Does it really make sense to make deductible IRA contributions when 100% of the withdrawal is for sure going to be taxed, at ordinary income rates no less!

    Wouldn’t someone be better off saving into a taxable account using index funds or stocks (if they have enough capital to diversify)? Sure the long term cap gains taxes could go extinct (especially if a democrat takes over the WH) but choices could be made then.

    Also Congress enacted to keep the tax benefits of the Roth IRA going and most experts feel that if any changes would happen those already in Roth IRA would be grandfathered. Never say never but it would be unthinkable for the gov’t to ever change existing 529 or Roth IRA tax codes on accounts already set up. It would be the largest bait and switch ever recorded.

    I like some of your commentaries but too often they are written with limited financial knowledege. This blog is good on the basics then it is on more complex financial situations. Just my opinion.

  2. Joshua says:

    It’s easy to criticize someone else’s writing. It also sounds like your talking about someone who has a lot of money to invest. If your like me and don’t have much, but still want to get started on saving for retirement a ROTH IRA is one of the best ways to go.

  3. jim says:

    JohnnyB: I didn’t recommend anything and this article was just an overview of the Traditional IRA, where do you find it lacking?

  4. Peter says:

    Traditional IRA’s are also better for those who believe that they will be in a lower tax bracket after retirement, than when they are setting the money aside.

  5. One minor correction. For the statement

    “if you make an early withdrawal on your Traditional IRA, you will have to pay taxes plus a 10% penalty. With a Roth, you can withdraw them at anytime…

    that is true only for the money you contributed. Any earnings from that money, if withdrawn, will have to have taxes paid and possibly penalties.

    i.e. You contribute $4000 and it accrues $200. If you take out the total ($4200) you will have to deal with paying taxes on the $200 and whatever penalties necessary.

  6. Matt says:

    I think that the possibility of future Roth taxation is overplayed. If the government ever decided to tax Roths they would have to turn the tanks out on all the old people rioting and marching in the streets. It would be serious political suicide for anybody that even considered voting for it. While I have absolutely nothing to back it up with, I would bet that an overwhelming percentage of the people who make political contributions have Roths and that counts more than voting these days. There would be hell to pay if it ever happened (and I’m not just talking about the IRS).

  7. jim says:

    Well, I haven’t heard much about future Roth taxation so I don’t know if it’s overplayed, I merely mentioned it because it deserved at least a little air-time, you know? I’ve actually had extensive conversations on the subject with MightyBargainHunter on it and I took the same side as you, Matt.

  8. Mase says:

    I started a Traditional IRA this year, anticipating a 2010/11 conversion with the phase-out of the income limitation, as this was the first year I could not contribute to my Roth IRA. As I will only pay taxes on the earnings, but not principal of my Traditional IRA, I thought it a good way to continue to sock away money into my IRA, knowing I can transfer it to my Roth come 2010/11 (and spread the tax hit, if significant, over both those years).

  9. katy says:

    some of us have a traditional ira because we couldn’t afford the taxes of the roth – too little income.

    (pfffft)

  10. JoeTaxpayer says:

    You know, I am skeptical of Roth Mania.

    There are two main reasons I still love the Traditional (Deductible) IRA.

    1) The chance that we will be in a higher bracket at retirement is slim, very slim. To just crack the 15% bracket (and not hit 25%) would take over $2M in pretax accounts.

    2) You are still young (Unless that’s an old pic, Jim) – what are the chances you will not be in a lower bracket than now in any year from now right through retirement? No chance of being out of work, underemployed, between jobs, wife takes time off, etc? Any year one is in the bracket lower than usual, they should convert enough to “top off” that bracket.


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