Traditional IRA accounts don’t have to be utilized just for retirement funds. Check out Traditional IRA pros and cons to see if an account makes sense for you.
As you work to enter the next big phase of your life, it’s sometimes easy to forget about planning for after your career, when you are just starting your career. I don’t remember sitting through interviews and new-hire orientations wondering, “what are some Traditional IRA pros and cons?”. I’m sure you aren’t either.
In my early twenties, I was thinking about a wedding I had coming up, saving for our first house, and what kind of car I could still afford to get me to the office every day. But I promise you the days are coming on planning for your future so you might as well jump-start the process and start looking now.
In today’s post, we will start with what a Traditional IRA is and see if it makes sense for you. Then we will head down the rabbit hole on Traditional IRA pros and cons.
- What is a Traditional IRA?
- Pros of a Traditional IRA
- Cons of a Traditional IRA
What is a Traditional IRA?
A Traditional IRA is an Individual Retirement Account in which you can contribute pre-tax dollars. What exactly does that mean? If you lose 20 percent (using easy numbers) to taxes on every single check, you can contribute to a Traditional IRA before those taxes are deducted. So instead of contributing $100 and it really turning into $80, you get to contribute the full $100.
A Traditional IRA can be full of different types of investments and has a ton of flexibility. You can choose to invest directly in stocks or bonds, or you can choose from any type of mutual fund that your brokerage company has to offer. A Traditional IRA account will have more options for investment than your typical 401(K) account.
You can open a Traditional IRA on most brokerage websites and manage the portfolio yourself, or you can work through a wealth advisor and let them make all the decisions.
Pros of a Traditional IRA:
If you are employed by a company that doesn’t offer a company 401(K) retirement program, you need to investigate setting up an IRA. However, even if you have a company offered program, it’s still a good idea to consider opening a Traditional IRA specifically.
I know for the first five or even six years I was employed by a major corporation, I took their 6.5 percent match 401(K) program and pension and just utilized that. Trust me, there is nothing wrong with that at all, but I soon found out when looking at Traditional IRA pros and cons, that I needed to get one set up immediately.
One of the biggest pros of a Traditional IRA is the contributions are tax-deductible (because you’ve already paid taxes on the money that goes into the account). So that means you can quickly cut your income by the amount you contributed throughout the year.
Another nice benefit of a Traditional IRA is you can contribute up to April 15th of the next year to last year’s balance. That means up to April 15, 2022 I can contribute towards my 2021 Traditional IRA for tax deductions.
A prime example of taking full advantage of a Traditional IRA happened to me just last year. My Adjusted Gross Income (AGI) was $3,200 into the next tax bracket. I had a Traditional IRA account already set up for my wife who had previously left a job that offered a retirement plan and needed it rolled.
After speaking to my tax advisor, he shared that if I contributed $3,200 into the Traditional IRA, I would get $3,000 additional in a tax return. So, by giving $3,200 into a retirement account, which could potentially be $20,000 in another 15 years, it cost me $200. I was completely shocked at this scenario as you often never feel like you win when you file taxes.
Side note – I have seen a ton of articles lately on the federal money that has been given the last two years for COVID-19 relief. Most of these payments are based on your AGI, so keep in mind you could utilize a Traditional IRA account if you are flirting with receiving any of those payments.
When evaluating Traditional IRA pros and cons, you also can’t forget about the tax-deferred growth benefit that you get. The investments that are in a Traditional IRA don’t face any tax consequences if they remain in the account. Remember, you can’t touch this money until the retirement age of 59 and a half without repercussion.
This tax-deferred pro is utilizing compound interest but at the most extreme level.
For example – you utilize a short-term investment strategy such as a CD Savings account and you earn seven percent on your $5,000 investment. That means you made $350 for the year, but now that money is subject to tax. If you assume a 25 percent tax rate, that means your earnings are now $262.50. Meaning that Uncle Sam took $87.50 out of your pocket and limited the growth.
Let’s look at this over a 20-year period. If you make seven percent on your Traditional IRA money (which is reasonable), utilizing compound interest each year, that money could be just shy of $20,000 in 20 years. Keep in mind, that is with zero additional contributions to the account.
If you lose 25 percent of your gains each year and still achieve a seven percent return, that money is just under $15,000 over a 20-year period. Again, that is assuming no further contributions to your money.
If these are truly retirement funds, you should not need the flexibility to have access, and you should utilize the compound interest opportunities on the money you gain. This is a prime example of your money doing the work for you.
Perhaps one of the most overlooked pros of a Traditional IRA is the flexibility on withdrawals before retirement age (59.5) for school reimbursements. You heard that right, Traditional IRA funds can be used to pay for a ton of eligible school expenses that include tuition, books, and certain other expenses.
Not only can you use these funds for college tuition, but they can also be used for private school tuition in grades K through 12 which is another fantastic benefit.
Here is a great example of how I utilize a Traditional IRA to my benefit. When I left a job that offered a corporate 401(K) program, I had roughly $75,000 of Roth IRA contributions and $25,000 of Traditional IRA contributions.
I rolled both into an account with a wealth advisor, but for the Traditional portion of the roll, I’ve earmarked it for my kid’s Tuition. A 529 account is great to save for college, but truthfully there aren’t a ton more advantages (depending on the state) than just using a Traditional IRA for college savings.
Now, I contribute to each of their 529’s each month, and I contribute to the Traditional IRA that can be used as well. If one of my kids would happen to get a huge scholarship, I can use anything extra in the account later for my own retirement. If I don’t have enough in the 529’s and need some extra, I can utilize it at no penalty. It’s as close to a win/win as you’ll find when it comes to finances.
Last but not least, you can also use funds from a Traditional IRA to go towards a first-time home purchase. Now, you must be careful to not rob from your future to buy a house when you are young, but with no penalty, it’s certainly an option for someone who has built up a decent amount of cash in a Traditional IRA.
I’ll admit, if you have $30,000-$50,000 sitting in a Traditional IRA, there is a good chance you aren’t strapped financially to buy a house. But, if you leave a job and roll a 401(K) to a Traditional IRA, I could see many scenarios where this is a feasible plan.
Why pay $2,500 of rent a month for a 1,500 square foot apartment with no garage or yard, when you could have a mortgage of $2,000 for a 2,000 square foot house, some land, and something that is yours? You could take those $500 monthly savings and build back your retirement account quickly.
Trust me, I understand more than anyone: when you are 24-years old, you don’t want to think about setting up additional retirement accounts, let alone giving your hard-earned money to it. You don’t have to necessarily contribute each month, but there are a ton of great reasons to at least consider opening a Traditional IRA account.
Cons of a Traditional IRA:
As with anything, you’re just doing your due diligence by weighing Traditional IRA pros and cons to what you need from an Individual Retirement Account. And while a Traditional IRA certainly has a ton of benefits, there are certainly some cons that you must consider.
The two biggest drawbacks of a Traditional IRA are the lack of flexibility to claim your money, and the tax penalty if you decide to withdraw before retirement age.
I’m not saying you can’t get your money back (fairly quickly) if you invest in a Traditional IRA, but the accounts are not meant to be liquid, and you will likely pay a 10% penalty on all of your early withdrawals. There are a few exceptions to investigate, but the standard age is 59 and a half to withdraw without penalty.
A Traditional IRA is definitely considered a long-term investment strategy and won’t perform to expectations if you are planning to take the money out early. Deposits into a Traditional IRA should only be money that you don’t plan on needing until retirement.
The other tricky item with a Traditional IRA is how the withdrawals are taxed. As we mentioned above, you get the tax deduction when you put money into a Traditional IRA, but you also are taxed as income when you make a withdrawal. That all makes sense; the issue can be your tax bracket at the time you start pulling funds from the account.
Let’s say when you started the Traditional IRA 30 years ago, you may have been in the 20 percent tax bracket. However, when you go to withdraw the money you are now in the 30 percent bracket, and you are forced to pay the higher rate on the money.
Another major drawback of a Traditional IRA is that there are limits to how much you can contribute each year. Everyone can only contribute up to $6,000 a year or $12,000 per family if you file with a partner or spouse.
That is a good chunk of money, but if you are truly funding your entire retirement without a 401(K) plan, you may find that at some point you will want to contribute more. Unfortunately, there is also a limit on how much of a tax deduction you can take as well.
If there was no limit, wealthier folks would put $30,000 or even $100,000 a year in Traditional IRA’s just to lose the income on their taxes.
By now you’ve seen multiple examples of Traditional IRA pros and cons and should have a better feeling of what will work best for your situation. Remember, even if you have a company-sponsored 401(K) program, there are a ton of advantages to having access to a Traditional IRA.
My recommendation would be to at least open an account with a wealth advisor. That doesn’t mean you need to contribute money to it right away, but having access to it will at least allow you to take advantage of some of the benefits.
It provides flexibility to deduct from your taxable income and can be a great way to save for your children’s college education, and not punish yourself if you over save.
If you don’t have any type of retirement plan through your work and are self-employed, getting a Traditional IRA set up is even more important for you. The above focuses on the benefits of a Traditional IRA and how the accounts can help move money around and save you on taxes, but at the end of the day, having money for your future retirement is the most important thing.
I’m certainly not qualified to make financial decisions for anyone, but after evaluating Traditional IRA pros and cons, there is very little risk for a chance to enhance your future.