What is a Traditional IRA? History of IRAs, Eligibility Requirements, Ineligible Compensation, Distributions from a Traditional IRA & How Income Tax Deductions Work

(August 8th, 2009)

According to the IRS, a traditional IRA is any IRA that is not a Roth or a SIMPLE IRA. Although similar, there are subtle differences between a traditional IRA and its counterparts, the Roth and Simple IRAs. The traditional IRA is also known as the “original IRA” or “regular IRA” because it was the first one that was ever invented in 1974. In traditional IRA plans, contributions are deductible from your gross income in the year you make those contributions and earnings grow tax-deferred. All gains made on investments and all contributions made over the working life of the employee will be subject to taxation upon withdrawals during retirement (when that investor retires and begins taking distributions) from his traditional IRA. These types of contributions are known as “pre-tax” IRA contributions.

History of IRAs

Individual Retirement Accounts (IRAs) were introduced to US citizens through the Employee Retirement Income Security Act (ERISA) of 1974. As Congress worked through the new plans, employees could contribute up to $1,500 to an IRA and reduce their taxable income by that contributed amount. At first, ERISA restricted IRAs only to those employees whose employers did not offer a company sponsored qualified 401(k) plan. This was however modified when the 1981 Economic Recovery Tax Act allowed all taxpayers under the age of 70 and ½ to contribute to an IRA regardless of whether they participated in other qualified plans or not. The Economic Recovery Tax Act also raised the maximum annual contribution to $2000 and allowed participants to contribute an additional $250 on behalf of a non-working spouse.

This created a huge interest among US workers to take advantage of IRA contributions and the ability to receive a deduction on their annual income tax filings. Thus, the popularity of IRAs grew enormously. However, the Tax Reform Act of 1986 was brought in to phase out the deduction for IRA contributions among higher-earning workers who are covered by an employment-based retirement plan themselves or who have a covered spouse.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) brought about further improvements to the IRA by raising the limits on IRA contributions starting from 2002 and allowing Catch up contributions for people aged 50 years and over.

Eligibility Requirements

You must be 70 and ½ years or younger to be eligible to contribute to a traditional IRA. Also, you must have earned a taxable or self-employment income to be eligible for participating in a traditional IRA. For working employees, the types of compensation considered are:

Note: The full list of eligible compensation is available @ http://www.irs.gov/pub/irs-pdf/fw2.pdf

Ineligible Compensation

The following types of income are not eligible for participation in a traditional IRA. They are:

Contribution Limits

Note: Catch up contributions are meant for those people who are 50 years or older and can make additional “catch up” contributions on top of their regular contributions.

Distributions from a Traditional IRA

- Distributions from a traditional IRA may be taken starting the age of 59 and ½ years old and any distributions taken before this age will be subject to income taxes & 10% early withdrawal penalty.

- Distributions can be taken in the form of periodic annuity payments or one lump sum amount.

- Distributions are taxed as ordinary income in the tax year when they are distributed. As well, people over the age of 70 and ½ are required to start taking distributions from your IRA by April 1 of the year following the year in which they reach 70 and ½ years age.

Deductions from Income Taxes

The amount of your annual contribution to a traditional IRA that is deductible from your income tax return depends on two factors and they are:

I) Whether or not your spouse participates in an employer sponsored retirement plan and

II) The amount of your adjusted gross income reported on IRS form 1040a – Line 21.

Your contributions can be fully deductible from your income tax return, or partially deductible depending upon the following 2 factors:

i) If you and your spouse do not participate in an employer sponsored retirement plan other than a traditional IRA, then your contributions to a traditional IRA are fully deductible from your income tax return, regardless of your adjusted gross income figure.

ii) If you and your spouse participate in an employer sponsored retirement plan, your combined adjusted gross income level will determine how much of your contribution is tax-deductible.