Individual retirement accounts (IRAs) can help you boost your retirement savings. Traditional IRAs come with their own set of rules, and it's important to understand the details before you open and fund one.
Let's break down the traditional IRA rules.
How to Open and Fund a Traditional IRA
Traditional IRAs can be opened by anyone 18 years old or older who has earned income. Part-time or full-time work suffices, as long as you can show how you earned that money.
For 2023 the maximum that an individual can contribute to a traditional IRA is $6,500. This is up from 2022 when the limit was $6,00. The IRS increases the limit every few years so that the accounts keep up with inflation.
If you have a Roth and a traditional IRA, you can put only $6,500 in total into both accounts. For example, you can put $4,000 into your traditional and $2,500 into your Roth but not $6,500 into each account. This is the government's way of keeping people from keeping too much of their income from being in a tax-advantaged account.
Contributions to your traditional IRA are tax-deductible in the year you make them. You pay tax when you withdraw the money in retirement. This makes them attractive to people who are in high-income tax brackets during their working years. They can avoid paying tax when they have a high tax rate and pay tax later, when their tax rate goes down. Contributions can thus grow tax-deferred. In order to plan your retirement better, we recommend using these free tools:
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Traditional IRA Withdrawal Rules
You can start taking money out of your IRA penalty-free at age 59½. But you don't have to start at that age — you can choose to let the account sit and grow for another 11 years if you choose. The IRS requires that you start taking minimum required distributions when you reach 70½ years old. Since the account is tax-deferred, the government needs you to take withdrawals at some point in order to collect taxes.
As soon as you start taking withdrawals, you will pay income tax on the money.
Penalties, Fees and Taxes on IRA Withdrawals
What if you want to withdraw money from a traditional IRA before age 59½? You can do it, but you'll pay a fairly high penalty.
Any early IRA withdrawal is subject to a 10% penalty. It will also be taxed as income at your current income tax rate. This can significantly cut into what you actually receive from the withdrawal. Why does the government impose this penalty on your own money? It doesn't want you to take money out of your retirement accounts early, as that can put you in a less stable position when you reach retirement age. If you're less stable, you may require government support.
Exceptions to the Penalties on Early IRA Withdrawals
There is an exception to every rule, and so it is for your traditional IRA early withdrawal rules. There are a few situations where you can avoid early withdrawal penalties.
1. Qualified Higher Education Expenses
You are allowed to use traditional IRA money (both your contributions and market growth) to pay for higher education expenses. This applies to education expenses for you and people in your family, such as your children, spouse, and even your grandchildren. The IRS doesn't place a limit on how much money you can take out of your IRA for this.
The money can be used for everything from tuition to supplies. You can even use the money to pay for room and board but not for a less-than-half-time student. So if you take only one class per semester, you can't use IRA money to pay for room and board. But if the student is more than at least half time, you can use IRA money to pay for room and board.
2. Buying Your First Home
You can withdraw up to $10,000 from your traditional IRA to put toward the purchase of your first home (here's our first-time homebuyers guide). The IRS defines a first-time homeowner as someone who hasn't owned a principal residence in the last two years. What's more, if you are married, your spouse can take out an additional $10,000 toward the house under this same rule, doubling what you can withdraw early.
The big catch here is that the withdrawal must be used within 120 days of the transaction. The government wants to make sure that you actually use it for the house and not just to pad your bank account. Read more about it here.
3. Death or Complete Permanent Disability
If you become totally disabled, you can withdraw money from your IRA without penalty. Similarly, if you die, your beneficiary or estate will be able to withdraw the money from your traditional IRA without any penalty. The IRS outlines some details on what “complete disability” means: You must be unable to earn money for yourself, and a doctor must certify your disability is long term.
4. Qualified Reservist Distributions (Military Exceptions)
Military members called to active duty for longer than 179 days get a penalty-free withdrawal. It must be made during the period of active duty. You can't take it before you are called up and you can't take it once your active duty ends. This could be helpful for a married military member who wants to send money to family at home while they are serving.
5. Medical Expenses and Health Insurance Premiums
You can take money out early for certain medical costs and situations. You can withdraw money to pay for:
- unreimbursed medical expenses that are more than 10% (7.5% if you are age 60 or older) of your adjusted gross income (AGI)
- health insurance premiums for you, your spouse and children while you are unemployed
When it comes to using the money for health insurance premiums, you are required to make the withdrawal no later than 60 days after getting a new job.
6. Substantially Equal Payments
You can avoid the 10% penalty if you start to withdraw money in an annual withdrawal for the remainder of your life expectancy. Meaning, if you take one early withdrawal, you must withdraw the same amount each ensuing year of your life.
You can modify your payment schedule after five years of withdrawals or when you hit age 59½, whichever is later.
If you're wondering how to calculate your life expectancy, the IRS provides a few worksheets for both single and married people to use.
Traditional IRAs can be a great way to save and invest your money for your golden years. However, make sure you follow the rules associated with these accounts to make the most of your savings.