5 Reasons to Avoid a Traditional IRA for Your Retirement Savings

Traditional IRAs stand out as potentially being the worst among tax-advantaged accounts when it comes to saving for your retirement. While the tax-deferred growth is nice, many of the rest of the rules around them can come back to bite you later.

Going in eyes wide open before you set up, fund, and attempt to grow your investments inside a Traditional IRA can go a long way toward helping you build a stronger plan for your future. With that in mind, here are five reasons to avoid a Traditional IRA for your retirement savings.

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No. 1: The returns are taxed as ordinary income when you withdraw them

Once you withdraw the money from your Traditional IRA for retirement, you pay ordinary income taxes on any returns you earned on your account above its taxable basis. Contrast that with money inside an ordinary brokerage account, where with careful tax planning, most of your returns could be taxed at a much lower rate on qualified dividends  or long-term capital gains .

No. 2: It can be hard to qualify to deduct your contributions

If you or your spouse are covered by a retirement plan at work, your ability to deduct your traditional IRA contributions can get limited fairly quickly. The table below shows the 2023 modified AGI limits above which you start to lose your ability to deduct your Traditional IRA contribution, based on your tax filing status.

Data source: Internal Revenue Service. 

If you can't deduct your contributions, then compounding your money in a Traditional IRA gives you something of a double-whammy. You're not only losing that immediate tax deduction, but you're also paying ordinary income taxes on your gains and dividends when you withdraw them in retirement. In many cases, that could make a non-deductible traditional IRA more expensive than just investing in an ordinary brokerage account.

No. 3: It can make Backdoor Roth IRA contributions more expensive

Due to income limits associated with making direct contributions to a Roth IRA, many people who want to take advantage of such a plan get their money into one via a Backdoor Roth IRA contribution. To use such a strategy, you first deposit money into your Traditional IRA and then convert the deposited amount into a Roth IRA.

If you don't have any money inside your Traditional IRA, then a backdoor Roth IRA contribution is treated similarly to an ordinary Roth IRA contribution from an immediate tax perspective. If you do have money inside your Traditional IRA, the IRS uses a pro-rata rule to determine what your conversion taxes are. In essence, you can find yourself in a situation where you both cannot deduct your initial Traditional IRA contribution AND are required to pay additional taxes on the amount you covert to your Roth IRA.

No. 4: High balances in retirement can make your costs skyrocket

Once you reach age 73 (increasing to age 75 by 2033),  you are required to take distributions from any of your retirement plans except your Roth IRAs. Those required minimum distributions (RMDs) create taxable income for you, just from the act of moving money from one pocket to the other. That taxable income can have several effects, including:

• Making up to 85% of your Social Security benefit taxable
• Increasing your Medicare Part B premiums
• Pushing you into a higher overall income tax bracket
• Subject your other investment income to the Net Investment Income Tax

No. 5: It can get expensive if you need to tap your money early

If you have a need to tap your retirement money before age 59 and a half, it can get very expensive to do so from your Traditional IRA. For general early withdrawals, you'll have to pay a 10% penalty  on top of your ordinary income tax rates. While there are ways to get around those penalties in certain circumstances, those exceptions are often ones that indicate that you're facing some pretty big issues. 

Going in eyes wide open can make a difference

With all those factors going against them, you might be wondering why you would even consider having a Traditional IRA. Despite those challenges, it can still play a role in your planning, particularly if you can use one as a temporary holding place for money on the way to your Backdoor Roth IRA. A Traditional IRA can also be a decent place for your money if you can both deduct your contribution and if you don't expect to have a large balance in your retirement accounts when you reach your RMD age.

With those trade-offs and downsides of Traditional IRAs in mind, make today the day you make a plan for how you get your mix of retirement accounts more efficient to help your reach your goals. The sooner you get started, the better your chances are of making any moves you need to make to enable your money to work the hardest it can for your future.