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What is a traditional IRA?
A traditional individual retirement account, or IRA, is a retirement savings account that allows someone to make contributions using her pretax dollars. Traditional IRAs have no income limitations and contributions to them are not taxed until retirement, making them the ideal choice for someone who expects to be in a lower tax bracket when she’s older.
Traditional individual retirement accounts are not taxed at the point of contribution, but rather at the point they’re withdrawn, meaning they provide a significant tax advantage to account holders later in life. However, if the money is withdrawn before the IRA’s designated retirement age of 59 1/2, the account holder will incur a 10 percent tax penalty from the Internal Revenue Service (IRS) unless the money is used for certain eligible expenses.
As of 2017, the maximum amount someone can contribute to her traditional IRA is $5,500 per year, until age 50, after which the maximum annual contribution becomes $6,500. The account holder can contribute until she turns 70 ½ years old, the age at which she must start withdrawing her money.
The account holder can deduct her contributions to a traditional IRA from her tax return, which is a tax benefit not offered to holders of other retirement accounts, such as the Roth IRA. Additionally, there is no income limitation on those who can contribute to an IRA, but the contributions must be funded with cash and fall under “taxable compensation,” which excludes tax-exempt income.
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Traditional IRA example
Kenny is opening up a traditional IRA after starting his first job at age 22. He expects to make the maximum contribution of $5,500 every year until he turns 50, after which he plans to contribute $6,500 per year. Because he plans to retire at 62, Kenny can expect that the 40 years of growth will amount to $1,205,005 in retirement.