Key Advantages and Disadvantages of a Traditional IRA

May 7th 2016

Pro: Tax Deductions

Individuals investing in a traditional IRA receive the advantage of deducting contributions on their annual tax returns. The deductions can feature tax benefits even if investors choose not to itemize their taxes. The primary benefit is that people investing in a traditional IRA pay lower tax rates in retirement than when contributing, which frees up funds when they are not earning income. The tax deductions only apply if individuals are not contributing to an employer-sponsored plan, though.

Con: Early Withdrawal Penalties

One primary downside to a traditional IRA is that people who withdrawal the funds prior to 59 1/2 years of age must pay an additional 10 percent tax penalty unless they qualify for an exception to the early withdrawal policies established by the government. The additional tax and penalties can significantly impact the balance of a traditional IRA and affect the financial future of a retiree.

Pro: Tax-Deferred Growth

All investments in a traditional IRA are tax-deferred as long as the funds remain in the account. Individuals are not required to pay taxes on the financial growth which means funds can earn interest without tax penalties. A stock investment that has considerable gains and growth cannot be taxed regardless of the amount of profit made when the funds are in a traditional IRA. This allows investors to reinvest the full amount of profit within other funds in a traditional IRA.

Con: Taxable Withdrawals

Penalties for early withdrawal are a considerable downside to a traditional IRA, but all withdrawals are also taxed at the current tax bracket of the investor. An investor who faces financial hardship and takes a withdrawal from a traditional IRA must pay taxes based on the income level at the time of the withdrawal. Individuals working at the time of a withdrawal are often classified in a higher tax bracket, which means they could face higher tax rates when the funds are needed prior to retirement.

Conclusion

A traditional individual retirement account, or IRA, is one of the many options for people planning for retirement. It is important for individuals to weigh the pros and cons when determining the best option for their financial future. While an IRA features several tax benefits, investors must also evaluate its limitations, which can impede the longevity of their funds.

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