How contributions and tax deductions work in a traditional IRA

When you open a traditional IRA, you put money in and that money may be tax-deductible in the year you contribute it. The IRS lets you deduct the full amount you contribute, up to an annual limit, from your taxable income for that year. The limit changes each year — the IRS publishes it in January, and it applies to anyone under age 50.

If you have a workplace retirement plan (like a 401(k)), your ability to deduct a traditional IRA contribution phases out once your income reaches a certain level. That threshold depends on your filing status and whether your employer offers a plan. If you have no workplace plan, you can deduct the full contribution no matter your income.

You can contribute to a traditional IRA as long as you have earned income from work. Once you turn 73, you can no longer make new contributions, though money already in the account continues to grow.

Key Takeaways

  • Money you put into a traditional IRA may reduce your taxable income in the year you contribute, lowering your tax bill that year.
  • Your contributions and all investment growth stay tax-free inside the account until you withdraw the money.
  • Starting at age 73, you must withdraw a set percentage of your balance each year, calculated by the IRS.
  • Withdrawals before age 59½ usually trigger a 10 percent penalty on top of income tax, with narrow exceptions for hardship or disability.
  • You pay income tax on every dollar you withdraw, at your ordinary tax rate, because the money was never taxed when it went in.

How your money grows tax-free inside the account

Once your contribution is in the account, you invest it — typically in stocks, bonds, mutual funds, or a mix. Any gains, dividends, or interest your investments earn are not taxed while they sit in the IRA. If you buy a stock for $1,000 and it grows to $2,000, you owe no tax on that $1,000 gain as long as the money stays in the account.

This tax-free growth is the main advantage of a traditional IRA. Over decades, that compounding effect can significantly increase your balance. You only pay tax when you take the money out, not as the account grows.

Required minimum distributions: when you must start withdrawing

At age 73, the IRS requires you to begin taking money out of your traditional IRA each year. These are called required minimum distributions, or RMDs. The amount you must withdraw is calculated by dividing your account balance (as of December 31 of the prior year) by a life expectancy factor the IRS publishes in tables.

If you do not take your RMD, the IRS charges a penalty equal to 25 percent of the amount you should have withdrawn (reduced to 10 percent if you correct it within two years). You calculate and withdraw the RMD yourself — your IRA provider will tell you the amount, but the responsibility to withdraw it is yours.

The RMD amount increases each year because your life expectancy factor decreases. If you have multiple IRAs, you can add up all the RMDs and withdraw the total from one account, rather than taking a separate withdrawal from each.

How taxes work when you withdraw money

Every dollar you withdraw from a traditional IRA is taxed as ordinary income in the year you withdraw it. If you contributed $5,000 and it grew to $8,000, withdrawing the full $8,000 means you pay income tax on all $8,000 at your regular tax rate — whether that is 12 percent, 22 percent, or higher, depending on your income bracket.

This is different from a Roth IRA, where may have access to withdrawals are tax-free. With a traditional IRA, the tax bill comes when you take the money out, not when you put it in. That is why the deduction at contribution time is valuable — you get a tax break now, but you pay it back later.

If you withdraw before age 59½, you also owe a 10 percent early withdrawal penalty on top of the income tax, unless an exception applies (see below).

Early withdrawal penalties and exceptions

Withdrawing money before age 59½ normally costs you a 10 percent penalty plus income tax on the amount withdrawn. However, the IRS allows penalty-free early withdrawals in specific situations: disability, medical expenses that exceed 7.5 percent of your adjusted gross income, health insurance premiums while unemployed, first-time home purchase (up to $10,000 lifetime), education expenses, or substantially equal periodic payments (a complex calculation that spreads withdrawals over your life expectancy).

Even with an exception, you still owe income tax on the withdrawal — the penalty is waived, but the tax is not. If you are under 59½ and need money, check whether your situation fits one of these exceptions before withdrawing, because the penalty is expensive and the IRS does not refund it if you later find out you did not may have access to.

Rolling over or converting a traditional IRA

If you leave a job and have a 401(k) or similar plan, you can move that money into a traditional IRA without paying tax or penalty. This is called a rollover. You have 60 days from the time you receive the money to deposit it into an IRA, or the IRS treats it as a withdrawal and taxes it.

You can also convert a traditional IRA (or a workplace plan) into a Roth IRA. When you convert, you pay income tax on the amount converted in that tax year, but the money then grows tax-free in the Roth and withdrawals are tax-free after age 59½. There is no income limit on conversions, though high earners may face a "pro-rata" tax issue if they have both traditional and Roth IRAs.

Comparing traditional IRAs to other retirement savings

A traditional IRA is one option among several. A 401(k) or 403(b) through your employer often has higher contribution limits and may include employer matching. A Roth IRA offers tax-free withdrawals instead of tax-free growth, which is better if you expect to be in a higher tax bracket in retirement. A SEP IRA or Solo 401(k) is designed for self-employed people and allows much larger contributions.

The choice depends on your income, whether your employer offers a plan, and whether you expect your tax rate to be higher or lower in retirement. Many people use more than one type of account to diversify their tax treatment.

Frequently Asked Questions

Can I withdraw money from my traditional IRA anytime I want?

You can withdraw anytime, but if you are under 59½, you will owe a 10 percent penalty plus income tax unless an exception applies. After 59½, you can withdraw without penalty, though you still owe income tax. At 73, you must withdraw at least the IRS-calculated minimum each year.

What happens if I contribute more than the annual limit?

Excess contributions are subject to a 6 percent penalty each year they remain in the account. You can withdraw the excess and the earnings on it before your tax deadline to avoid the penalty, or you can carry the excess forward and deduct it in a future year if you have room under the limit.

Do I have to take my required minimum distribution all at once?

No. You can take it in monthly, quarterly, or any other schedule throughout the year, as long as the total by December 31 meets the IRS requirement. Your IRA provider can set up automatic distributions if you prefer.

What if I inherit a traditional IRA from someone else?

Rules depend on your relationship to the person who died and when they died. Spouses can roll the IRA into their own account. Non-spouses generally must withdraw the entire balance within 10 years, though some exceptions exist. The withdrawals are taxed as ordinary income.

Can I deduct my traditional IRA contribution if I have a 401(k) at work?

It depends on your income. If your employer offers a 401(k), your ability to deduct a traditional IRA contribution phases out above a certain income threshold. The IRS publishes these thresholds each year based on filing status. You can still contribute to the IRA, but the contribution would not be tax-deductible.