Why Traditional IRAs Are So Popular

“The popularity of IRAs stems from the fact that not only do they offer an easy way to save money for retirement, but they may offer a current tax break as well,” explains Martin Walcoe, executive vice president at David Lerner Associates. “Depending on several different factors, you may be able to deduct the contributions you make to your traditional IRA each year, which can lower your current taxes.”

Annual Contribution Limits

When IRAs were first established, the contribution limit was just $1,500 per year, or only $125 a month. That’s a nice start, but most people want to stash more than this in their retirement accounts. So starting in 2002, Congress changed the rules and started indexing the annual contribution limit for inflation. Since then, it has more than doubled—to $5,000 a year, or $416 a month, in 2012.

The news is even better if you’re 50 years of age or over: You can make what are called “catch-up contributions” of an extra $1,000 a year. This brings the total contribution limit up to $6,000 a year, or $500 a month, for anyone at least 50 years old. However, once you reach age 70½, you can no longer make contributions to a traditional IRA, and you must begin taking required minimum distributions (RMDs) from your IRA at this time.

The key benefit of a traditional IRA is the opportunity it provides to potentially benefit from long-term, tax-deferred asset growth. IRA funds grow without the burden of taxation until distributions begin, at which time the funds are taxed at ordinary income rates.

Since IRAs are designed primarily as a retirement savings tool, a 10% early withdrawal penalty generally applies to any funds that are withdrawn before age 59½. This penalty is in addition to federal income taxes that are due upon withdrawal. There are a few exceptions in which the penalty is not assessed, such as to pay unreimbursed medical expenses and medical insurance premiums, to purchase a first home, or to meet qualified higher education expenses, among others.

Are Your Contributions Deductible?

If you do not participate in an employer-sponsored retirement plan at work, you generally can deduct the full amount of your annual IRA contributions. But if you do participate in an employer-sponsored retirement plan, the amount of your deduction will be limited or eliminated based on your modified adjusted gross income (MAGI):

• If your MAGI is between $58,000-$68,000 (if you’re single) or $92,000-$112,000 (if you’re married and file jointly) in 2012, your deduction is phased out incrementally.
• If your MAGI exceeds these amounts in 2012, you cannot deduct your annual IRA contribution.

IRA contributions can be made up until your tax-filing deadline (not including extensions), which means you likely have until this April 15 to make a full contribution for tax year 2011. Therefore, it might be wise to sit down with your investment counselor and accountant to determine if making a traditional IRA contribution is a smart move for you.