Understanding Traditional IRA Rules

Unlike a 401(k) plan, a Traditional IRA is not a workplace benefit. It is an investment account that provides special tax advantages to people who can follow IRA rules and can wait until they reach retirement age to make withdrawals.

There are two tax benefits associated with using a Traditional IRA to prepare for retirement: the possibility of claiming a tax deduction for the amount of your contribution, and the ability to earn tax-deferred investment returns. Tax deferred means that the investment earnings in a Traditional IRA are not taxable every year. Instead, taxes are delayed until you begin making withdrawals. At that point, withdrawals from a Traditional IRA will be taxable as income at then-current tax rates. Early withdrawals are taxable as income and may also incur a 10% penalty tax.

It's important to familiarize yourself with all of the IRA rules and eligibility guidelines. For example, contributions to a Traditional IRA are only deductible for people with income low enough to qualify. For people earning more than a certain amount, contribution deductibility may be "phased out," which means that you may not be able to deduct the full value of your Traditional IRA contributions. In addition, there are limits to the amount of money you can contribute to a Traditional IRA each year.

Tax benefits of Traditional IRAs
The main benefit of a Traditional IRA is its status as tax-advantaged investment account. You won't pay taxes on your investment growth as long as the money stays in the account. The other key benefit of a Traditional IRA, if you qualify, is the tax deduction you can get from your annual contributions. In other words, a Traditional IRA not only helps you set aside money for the future, but it may also help you save on taxes right now.

Your ability to deduct contributions to a Traditional IRA is affected by whether you or your spouse participate in an employer-sponsored retirement plan, such as a 401(k). If you're single and contributing to a plan at work, you can deduct your contributions if your adjusted gross income (AGI) is $53,000 or less. For married couples where one or both partners uses a retirement plan at work, the income limit for deductible contributions is an AGI of $85,000 or less. If you're married and file as a Head of Household, the limits for a single taxpayer apply.

Eligibility for Traditional IRA deductions phases out for single taxpayers with income between $53,000 and $63,000 and for married taxpayers filing jointly earning between $85,000 and $105,000. Single taxpayers and married taxpayers filing jointly who earn more than $63,000 and $105,000, respectively, cannot claim any tax deductions for Traditional IRA contributions.

If you earn too much to claim a deduction for your contribution to a Traditional IRA, then you should consider the potential benefits of a Roth IRA. Roth IRA contributions aren't tax deductible, but earnings growth and qualified withdrawals are federally tax free. Income limits apply to Roth IRAs as well, but they're much higher. In 2008, contribution limits phase out between incomes of $99,000 and $114,000 for single and Head of Household filers, and incomes between $156,000 and $166,000 for married couples who file jointly. If you make more than the maximum AGI allowed, you can't contribute to a Roth IRA.

If you can't claim a deduction for Traditional IRA contributions, it doesn't make sense to take a tax hit on your withdrawals. It makes more sense to contribute to a Roth IRA and receive tax-free withdrawals during retirement.

Traditional IRA contribution limits
If you are under the age of 50, the maximum amount of money you are allowed to contribute to a Traditional IRA in 2008 is $5,000. You can contribute this amount regardless of whether you are eligible to claim a deduction for using a Traditional IRA. But if you are over the age of 50, the IRS allows an additional contribution, often referred to as a "catch-up contribution," up to $1,000. So if you already blew out the candles on your 50h birthday cake, you can contribute a total of $6,000 to a Traditional IRA.

These contribution limits are expected to increase each year at a rate of about $500 per year, depending on inflation. The AGI limits for tax-deductible contributions and Roth IRA eligibility also increase each year.

Traditional IRAs vs. 401(k) plans
As attractive as a Traditional IRA may be, don't overlook the potential value of your workplace 401(k) plan. In many cases, it may make more sense to contribute to a Traditional IRA only after contributing as much as possible to your 401(k). For example, if your employer makes a matching contribution each time you contribute to your 401(k), you're basically receiving free money every payday. Since an IRA is a personal account, there's no matching contribution.

Contribution deadlines for traditional IRAs
Finally, keep in mind that the deadline for making Traditional IRA contributions in a particular year is the same day as the federal tax-filing deadline for that year, which falls in mid-April (usually April 15) of the following year. That means you can wait until early in 2009 to determine your 2008 taxable income and then determine whether you want to make a 2008 contribution to your Traditional IRA. You'll need to make the contribution before you file your federal income tax return, and filing for an extension won't extend your contribution deadline.

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