What Is A Traditional IRA? Investing Basics

Posted on August 18, 2014 at 8:58 AM PDT by

The short and sweet answer is that an IRA is an individual retirement account. What throws people, sometimes, is that an IRA is often better described by what it’s not.

It’s not a 401(k), for instance. Those are workplace plans that are administered by your employer (although, increasingly, sole proprietor business owners can open them). They’re not pension plans, which is what preceded the 401(k).

traditional ira

Because a great number of people have either a 401(k), a pension or both, many of them never open an IRA or even consider opening one. That’s a mistake, for reasons we’ll explain.

First, about the word “traditional.” It really only defines an IRA as not being a Roth IRA. The important point there is that a traditional IRA allows you to defer taxes today, while a Roth allows you to take money out tax-free later.

So, what is a traditional IRA and why open one at all? Here are five scenarios where it makes sense:

1. You job-hop a lot

One reason to open an IRA is to have a bucket into which you can roll money from your previous employer 401(k) plans. If you have two or three past employers, chances are the money you saved or were given as matching is still sitting in those accounts. A single IRA can accept all of those balances with no tax impact today, presuming you roll them over correctly.

2. You or your spouse is the breadwinner

If you are in a 401(k) plan and making the maximum contribution, you’ve likely hit your limits on annual retirement plan savings. But your non-working spouse can still put away money, even with no income at all. The IRS realizes that the earning half of the couple is making the contribution. The limit is lower but certainly enough to improve your retirement picture.

3.  Your workplace 401(k) is terrible

There are a lot of reasons to contribute money to a workplace plan, such as free money in corporate matching and discounted company stock gifts. But you might not like the investment options in those plans, and they can be expensive. If not, consider putting enough away at work to get the match and then upping your IRA contribution to reach your personal annual limit.

4. You are cashing out

Leaving a longtime employer? They would like very much for you to stay in the workplace 401(k) for life. That might be a good idea in the case of some large employers with very well-run, inexpensive plans, or if you are a federal employee in the Thrift Savings Plan. If you are not, an IRA that you manage or you manage along with a financial advisor could be cheaper and more in line with your needs.

5. You plan to work in retirement

You can contribute to an IRA until age 70 and 1/2. Why would you? Well, if you make a lot of money as a consultant or contractor while in your 60s, it might be worthwhile to lower your taxes now and pay less taxes later, when you are no longer working and perhaps in a lower bracket.