Investment Tips: What Is A Traditional Ira

There are many factors to consider when deciding what kind of IRA to open. This article will help you decide if a traditional IRA is right for you.

For most people concerned about planning for retirement, an individual retirement account (IRA) is an absolute necessity. These are investment account which allow the individual to contribute a certain amount of money each year, the earnings of which grow tax-free so long as the rules of the account are followed. There are different types of IRA's, but for the purposes of this article we will discuss the Traditional IRA.

There are a number of guidelines and rules one must follow when establishing and funding a traditional IRA. First, you have to open an IRA with a designated financial institution who will hold the money for you and execute any trades or investment that you perform. This can be a bank, mutual fund, brokerage firm, or other investment company qualified to offer IRA's. Second, the account has to be officially designated as an IRA account. This means you can't go open a checking account at the local bank and then call it your IRA when it comes tax time.

Once you open the IRA, you need to fund it, but there are limits as to how much money you are allowed to put into the account. These limits are in place largely because of the tax-free nature of the earnings, and the deductions associated with contributions. For 2004, the limit for an individual to contribute to a traditional IRA is $3,000. However, if you turned 50 or older by the end of 2004, you are eligible to make a so-called "catch-up" contribution, of an extra $500. The limit for how much money you can contribute to an IRA will gradually rise over the next few years, up to $5,000 per year by 2008. The advantage of the traditional IRA is that no matter how large your income is, you still qualify to put in the maximum contribution to the account, whereas for other types of IRA's your contributions are limited by how much money you make, or you may not qualify at all to contribute. However, if you made less than $3,000 for the year, you can only contribute up to the amount of your income.

Another advantage of the traditional IRA is that any contributions you make into the account are tax deductible, provided you fit into the income guidelines established by the IRS. How much you can deduct depends on a number of factors: your modified adjusted gross income, which for most people is the same as their adjusted gross income; your filing status; whether you are covered by a retirement plan through your employer; and whether or not your received social security benefits. Even if you do not qualify for a tax deduction, though, you can still make the contribution to the account. This is known as a non-deductible contribution, and must be reported to the IRS using Form 8606.

Yet more good news about IRA's, including traditional IRA's, is that if you make a contribution, you may qualify for a tax credit. This is known as the retirement savings contribution credit, and is designed to reward people who don't make a lot of money but make an effort to save for retirement anyway. If your adjusted gross income is less than $25,000 if you are filing individually, or $50,000 if you are married filing jointly, you may qualify to take a percentage of whatever you put into your IRA as a credit toward taxes paid. If you think you qualify, you need to file IRS Form 8880.

There are some disadvantages to traditional IRA's, particularly regarding distributions. With other IRA's, such as the Roth IRA, there is no requirement for taking distributions, and the distributions themselves are not taxed (this is because they are not allowed as deductions when they are contributed), but with the traditional IRA, you must begin taking distributions from the account by the following year after you turn 70 and a half, regardless of whether you want to withdraw money from the account or not. The second disadvantage is that these distributions are counted as ordinary income and taxed accordingly. This is because when the contributions were made initially, they were taken off as deductions for the contribution tax year. Now, though, you have to pay for it - this is something to keep in mind when deciding whether or not a traditional IRA is the right option for you.

There are advantages and disadvantages to every kind of IRA. However, if you make too much money to qualify for a Roth IRA, a traditional IRA may be the best route for you. In the end, the important thing is to make sure you open some kind of IRA - it is never too early or too late to start planning for the future.

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