Investors love IRAs, and understandably so. Lowering your current tax bills and postponing taxes on gains made within a retirement account means you've got more money to put to work right now. That means a bigger nest egg later. It's a no-brainer.
However, a traditional IRA isn't necessarily your best choice in comparison to a Roth IRA or a work-based retirement account like a 401(k). Here's a closer look at four reasons you might not want to fund a traditional IRA and instead consider a different retirement savings option.
1. Traditional IRA distributions are eventually mandatory
If you're lucky enough to know you won't need the money you'd be tucking away in a traditional retirement account -- nor its tax-sheltered growth -- you may not want to bother putting it in such an account in the first place. That's because the Internal Revenue Service will eventually make you take it out of the account anyway.
These required minimum distributions (or RMDs) begin in the year you turn 73. Although it's not a hard-and-fast rule, these RMDs start out at about 4% of your IRA's value, and are designed to totally deplete it in the year in which you would turn 120 years old. Of course, most people don't make it that far; many peoples' IRAs outgrow the IRS's required distribution schedule anyway.
If you were planning to pass a traditional IRA account in its entirety along to an heir, assuming you live at least into your early 70s, that becomes increasingly complicated to do.
2. Traditional IRA distributions are usually taxable
Being forced to whittle down your traditional retirement account's value is only half the issue. Also bear in mind that these withdrawals are considered taxable income once they start coming out.
There's one exception to this taxability rule. That is, if for some reason you weren't able to deduct some of your past IRA contributions from your previous taxable income, you won't owe taxes when this portion of the account's value is taken back out. It can be tricky to figure out and identify this piece of your IRA portfolio, though. The IRS's form 8606 must also be filled out for the tax year in which you put this non-deductible contribution into the retirement account in question.
Not sure about your particular case? Most people probably don't have non-deductible contributions in their traditional IRA. You'll want to speak with your accountant or qualified tax professional, however, to find out for sure if you qualify for this slight tax break.
3. Early withdrawals from traditional IRAs are typically penalized
The money you put into a traditional IRA isn't completely locked up until you turn 72 or 73 years old. You can get to it at any time once it's put in. Any funds you remove before you turn 59 1/2, though, are not only taxed as income but then penalized an additional 10%.
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Again, there may be some limited exceptions. If you become disabled, for instance, or are putting the money toward a college education or certain medical expenses, then it might not be penalized. As is the case with removing non-deductible contributions when you start withdrawing money, you'll want to make sure you're keeping good records of everything.
4. Your traditional IRA contribution may not actually be tax-deductible
Finally, perhaps the most appealing aspect of a traditional IRA is that the contributions you make to it lower your taxable income in the year the contribution is made.
But these contributions aren't always completely -- or even partially -- tax-deductible.
For most people, they will be. If neither you nor your spouse are eligible to participate in a retirement plan at your places of work, you can both "max out" your respectively allowed contributions for your age, and deduct the whole amount from taxable income. This of course lowers your current tax bill.
Things get trickier if you or your spouse are able to participate in an employer-sponsored retirement plan, though. Single people of this ilk can only deduct all of their traditional IRA contributions if their adjusted gross income is less than $73,000. If you're earning more than $83,000, none of your IRA contribution is tax-deductible. For earnings in between those two figures, partial deductions are possible. For married people filing jointly, the deductibility tiers start at combined gross incomes of $116,000, with earnings of more than $136,000 disqualifying you from deducting any of the contribution. Again, gross incomes between those two numbers allow for partial deductions of traditional IRA contributions from your taxable earnings.
It's not that Roth IRAs don't have income-based contribution limits, but in some cases it may make more tax sense to fund a Roth or a 401(k) account instead of messing with a traditional retirement account.
