Traditional IRAs are retirement accounts that provide an upfront tax benefit and a greater selection of investment options than most 401K plans.  Learn the tax rules that govern these accounts to see the lesser-known benefits of these unique investment vehicles.

Contribution Rules

Traditional IRAs can be contributed to as long as you have earned income, meaning that wages were earned from work performed as an employee or through self-employment.  Spouses who do not earn wages themselves can contribute to their own accounts if their spouse has earned income.  The only stipulation is that the contribution amount is the lesser of either earned income or the contribution limit established by the IRS.

For 2021, the maximum amount an individual can contribute to all personal IRAs is $6,000.  If you are age 50 or older, you are permitted to make a “catch-up” contribution of $1,000 each year.  These limits exclude contributions made to SEP and SIMPLE IRA accounts that are offered by employers.

Prior to 2020, contributions to Traditional IRAs were not permitted past the age of 70-1/2, regardless of whether an individual had earned income or not; but beginning in 2021, there is no age restriction.

The deadline for making contributions to a Traditional IRA is the tax filing date, which is typically in mid-April.  This provides an additional four months to the contribution window each year and that makes the account an excellent strategy for last-minute tax reduction.

Tax Rules

Unlike Roth IRAs, contributions to a Traditional IRA are tax-deductible, meaning that your contribution reduces the amount of income that is subject to ordinary income taxes.  In most cases, the full amount is tax-deductible.  However, the tax deduction may be limited or disallowed if you or your spouse are “covered” by an employer-sponsored retirement plan.  You’re generally considered covered if you have access to and are eligible to participate in a plan, including a pension.

As the money in a Traditional IRA grows in value, the earnings and gains that accrue are tax-free, meaning that taxes are not due each year on interest, dividends, or capital gains.  Moreover, securities can be sold at any time and frequency in the account without creating tax liability.

It is only when money is distributed (withdrawn) from a Traditional IRA that it becomes taxable.  When this occurs, the total amount withdrawn is counted as earned income and is subject to ordinary income tax rates, which are the same rates that apply to income from wages.

As for penalties, there are primarily three that apply to Traditional IRAs and each arises under specific conditions.  They are the 6% penalty on excess contributions, 10% early withdrawal penalty, and the 50% penalty for failing to satisfy the required minimum distribution.

Rules Governing Investment Options

IRAs offer the broadest access to investment options available on the market.  Stocks, bonds, mutual funds, and ETFs are the most common securities used to build investment portfolios, and within an IRA, account holders can choose from a universe of options.

This is different than what is typically found in company-sponsored retirement plans like 401K, 403B, and 457 accounts.  Employer plans tend to limit investment options to mutual funds and company-specific stock.  Moreover, the funds employers make available to employees tend to lack wide-ranging international and bond exposures, which can make it harder to build a diversified portfolio that emphasizes the importance of asset allocation.

Just as critical as the investment options are the fees charged in employer accounts.  The fund options offered may have higher average expense ratios than comparable alternatives found when investing through an IRA.  Administrative fees in company retirement plans can also be significant, especially for small and mid-sized businesses.  Since the impact of fees can have a substantial impact on what remains in your account when you reach retirement, it makes sense to compare your options.

Rollover & Transfer Rules

The terms rollover and transfer are often used interchangeably, but the difference determines if a transaction is reportable to the IRS or not.  What is more crucial is whether the transaction is direct or indirect.

With direct transactions, the account owner never takes custody of the funds and therefore the transaction does not create tax liability.  There are also no limits on the number of direct transactions that can be performed in a given year.

Conversely, indirect transactions, and especially indirect rollovers, are fraught with potential problems.  Not only are account owners limited to one (1) indirect transaction every 365 days, the transactions themselves are subject to additional rules.  For instance, when initiating an indirect rollover from a company-sponsored plan like a 401K, the IRS stipulates that a 20% mandatory tax withholding be made by the employer on the funds being distributed.  This occurs regardless of whether the account owner intends to redeposit the money into an IRA or not.  Moreover, the IRS stipulates that indirect rollover deposits occur within 60-days of the funds being disbursed or the transaction is considered a permanent distribution.  If the rollover amount is sizable, the tax consequences could be massive.

For these reasons and others, it is almost never a good idea to perform an indirect rollover.  Instead, it is best to review with a financial advisor the options you have with your retirement account when you leave your job.

Distribution Rules

Money withdrawn from a Traditional IRA is always taxable.  Additionally, if distributions occur prior to age 59-1/2, a 10% penalty may apply unless the withdraw is considered qualified.  Based on IRS rules, the following exceptions apply to the penalty on early distributions when they occur as a result of:

  • Unreimbursed medical expense greater than 7.5% of AGI
  • Payment of health insurance premiums during a period of unemployment
  • Total and permanent disability
  • Series of substantially equal periodic payments
  • Qualified higher-education expense
  • First-time home purchase (limited to $10K)
  • IRS tax levy
  • Qualified military reservist withdrawal
  • Withdrawal for a qualified birth or adoption (limited to $5K per child)

Beginning at age 72, withdrawing money from a Traditional IRA is mandated under a rule called Required Minimum Distributions (RMD).  Through the SECURE Act and after the year 2020, anyone with a traditional (pre-tax) retirement account is required to withdraw a minimum amount from their account beginning at this age.  The first RMD can be delayed until April 1st of the year after reaching age 72, but distributions in subsequent years need to be completed by December 31st to avoid penalties.

RMDs are generally calculated by taking the prior year’s ending balance and dividing it by the applicable life expectancy factor published by the IRS.  RMDs are calculated for each pre-tax account that a person owns.  The total amount can be taken proportionately from each pre-tax account or aggregated and taken from a single account to satisfy the requirement.


Traditional IRAs are one of several types of retirement accounts that offer tax incentives to those who contribute to them.  They also provide the widest array of investment options available, which can make them ideal for building diversified investment portfolios and managing costs.  If you need help navigating the rules for these or any other investment accounts, contact us today.

Chris Yeagle

Chris Yeagle

Principal & Financial Advisor - Honeygo Financial

Chris began his career as a financial advisor with Merrill Lynch where he developed retirement plans for hundreds of clients and helped those he served to simplify their strategies and manage their investments.  He is a graduate of the University of Baltimore’s Merrick School of Business and he holds a Master of Finance from Loyola University.  Chris and his family are life-long Marylanders, who enjoy traveling the country visiting new places and old friends.

Honeygo Financial is a registered investment advisory firm offering services in Maryland and in other jurisdictions where exempted.  All written content is for informational purposes only and should not be considered tax, legal, insurance or investment advice. Opinions expressed herein are solely those of the firm, unless otherwise specifically cited.  Material presented is believed to be from reliable sources and no representations are made as to its accuracy or completeness.