The money you put into a traditional individual retirement arrangement is generally tax deductible, but the process works slightly differently from employer-arranged plans like a 401(k) or a SIMPLE IRA. You generally still have taxes withheld from your paycheck for the money you'll ultimately put into your IRA, but you'll get those funds back when you file your taxes the following year.
You can invest pretax dollars in your traditional IRA in the sense that money you put in is tax deductible, but you must wait to file your taxes, unlike pretax contributions to an account like a 401(k).
Pretax Investments and IRAs
An IRA is a type of retirement account that you can open for yourself with a brokerage, bank or other financial institution. You're allowed to contribute a certain amount every year, generally up to $5,500. If you are 50 or over, you can contribute up to $6,500.
You're also only allowed to deposit as much as you earned in a given year, so even if you have more in savings, you normally can't transfer it to an IRA if you didn't earn enough that year. The money that you deposit into the account is deducted from your taxable income when you file your taxes, netting you a larger refund or smaller tax bill.
This is slightly different from an employer plan like a 401(k), 403(b) or SIMPLE IRA. There, money is generally taken from your paycheck to deposit into the retirement plan with no federal income tax withheld from those funds. Once you file your taxes and get a refund or settle your IRS bill, the net result is the same but in the meantime, the pretax contributions from a work plan mean more money immediately in your pocket.
When you retire, you can remove money from an IRA, though you must pay tax on it as ordinary income at that time. Generally, until you reach the retirement age of 59 1/2, you can't take money out of an IRA without paying that deferred tax as well as an additional 10 percent tax penalty. Some exceptions apply if you're unemployed and need health insurance, are paying for certain educational or healthcare costs, are spending up to $10,000 on a first purchased home or are called to active military duty.
You can also transfer, or roll over, an IRA from one provider to another without a tax penalty.
After you reach age 70 1/2, you are required to take mandatory minimum withdrawals, called required minimum distributions, from your IRAs each year or face a steep tax penalty. It's generally 50 percent of the difference between the required minimum and your actual withdrawal, meaning you'll owe more tax by not withdrawing the funds than you would in even the steepest tax bracket.
Understanding Roth IRAs
In addition to traditional IRAs, there is a separate type of IRA called a Roth IRA. With this type of account, your contributions aren't tax deductible at all. You pay tax on earnings as normal and then deposit them into your Roth IRA. Your total deposit limits apply across all Roth and traditional IRAs.
Instead, when you reach retirement age, you can take your Roth IRA funds, including any earnings, and withdraw them tax-free. This can be advantageous if you anticipate being in a high tax bracket at retirement time.
You can convert a traditional IRA into a Roth IRA through a formal process that involves paying the deferred tax.
2018 Tax Law Changes
The laws around retirement accounts aren't changing much for 2018, but tax brackets are shifting, so tax rates are generally lower. This will affect how much some taxpayers will save using such retirement accounts.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.