When traditional IRAs make sense in retirement planning

[UNITED STATES] When planning for retirement, it’s essential to consider how different types of accounts can help you save efficiently. One type of account often discussed is the pre-tax retirement account, including the traditional IRA. These accounts are often referred to as an "IOU to the IRS" because while you can defer paying taxes on the contributions today, you’ll eventually pay taxes when you withdraw the funds in retirement.

While this might sound like a potential downside, there are times when using pre-tax retirement accounts makes perfect sense. Understanding the dynamics of these accounts and how they fit into your overall tax strategy is key to maximizing your retirement savings.

A pre-tax IRA, or Individual Retirement Account, allows you to contribute money before taxes are taken out of your income. The money grows tax-deferred until you withdraw it in retirement. This means you don't pay taxes on the funds as they grow — but eventually, when you make withdrawals, they will be taxed as ordinary income.

For many people, the appeal of pre-tax retirement accounts is the immediate tax benefit. You get to lower your taxable income in the year you make the contribution, which may even move you into a lower tax bracket. However, it’s important to remember that you’re postponing your tax bill to the future.

Why Is It Called an ‘IOU to the IRS’?

In a sense, pre-tax retirement accounts like IRAs are considered an "IOU to the IRS" because while you are not paying taxes on the contributions now, you will owe taxes when you withdraw the money. The government allows you to delay taxes on your contributions, but it expects you to pay when you take distributions, typically after age 59½.

The concept of an IOU implies that the taxes are deferred, not forgiven, so it’s important to plan ahead for the tax liability that will arise in retirement. As tax rates change over time, future withdrawals could be taxed at higher rates than they would have been if you paid the taxes upfront.

When Does It Make Sense to Use Pre-Tax IRAs?

Pre-tax retirement accounts may not be for everyone, but they are an excellent tool for many individuals. Here are some scenarios where it might make sense to contribute to a traditional IRA or another pre-tax account:

If You Are in a High Tax Bracket Now, But Expect to Be in a Lower Tax Bracket in Retirement

One of the main reasons to use pre-tax retirement accounts is the immediate tax savings. If you’re currently in a high tax bracket, contributing to a traditional IRA or a 401(k) can lower your taxable income for the year. This means you may pay less in taxes today than you would if you were to pay them upfront.“For people who expect to be in a lower tax bracket when they retire, it can make a lot of sense to take advantage of a pre-tax IRA,” said Sarah H. (an expert financial planner), in a recent interview. “By contributing now, you’re lowering your taxable income, and you’re deferring taxes until retirement when your income—and therefore your tax bracket—may be lower.”

If You Need to Lower Your Taxable Income

For some individuals, reducing their taxable income can provide immediate financial relief. Contributing to a pre-tax IRA allows you to do just that. By lowering your taxable income, you may be able to avoid or reduce your exposure to higher-income tax rates or tax penalties. It could even allow you to qualify for tax credits or deductions that you wouldn't have been able to access otherwise.

For Employers Who Offer Matching Contributions

If your employer offers matching contributions to your 401(k) or similar retirement plan, it may be worth considering the pre-tax option. You don’t pay taxes on the contributions your employer makes, and the contributions can grow tax-deferred until retirement.In cases like this, experts recommend contributing to the retirement plan, especially if the employer match is a significant percentage of your salary. This is essentially “free money” that you would be leaving on the table if you didn’t take advantage of it.

When You Expect to Have Higher Income Later in Life

Some people use a pre-tax IRA as a way to defer taxes when they are in their peak earning years, knowing that they may have a period in retirement where they are earning less. In such cases, it makes sense to take advantage of the lower taxes available during their high-income years and pay taxes during retirement when their income may be lower.

For Younger Savers Who Can Benefit from Long-Term Growth

Younger savers can use a pre-tax IRA to accumulate tax-deferred earnings over time. Because they have a longer time horizon, the potential for tax-free growth can significantly increase the value of their retirement savings. Over decades, the tax-deferred growth can compound, offering significant retirement benefits in the future.

How Pre-Tax IRAs Work

The mechanics of a pre-tax IRA are simple. You contribute money to the account, and in doing so, you reduce your taxable income for the year. This can provide an immediate tax break. The funds in the account grow without being taxed, and you don’t have to pay taxes on the money until you withdraw it.

For example, let’s say you contribute $6,000 to a traditional IRA in 2025. If you are in the 24% tax bracket, that $6,000 contribution could reduce your taxable income by $6,000, meaning you could save about $1,440 in taxes for the year. You wouldn’t pay taxes on the $6,000 until you withdraw it in retirement.

The catch is that there are required minimum distributions (RMDs) starting at age 73 (as of 2025), which means you must start withdrawing money from the account and paying taxes on those withdrawals once you reach that age.

The Risks of a Pre-Tax IRA

While pre-tax IRAs offer many advantages, there are also some risks to consider. The biggest risk is the uncertainty of future tax rates. While you may be saving on taxes today, there’s no guarantee that tax rates will remain the same when you withdraw your funds in retirement. If tax rates increase, you could end up paying more in taxes on your IRA withdrawals than you would have if you had paid taxes upfront.

Another risk is the possibility of withdrawing money early. If you take money out of a pre-tax IRA before age 59½, you’ll face a 10% early withdrawal penalty, in addition to owing income taxes on the withdrawn amount. This can significantly reduce the amount of money available for retirement.

When to Consider Other Options

Pre-tax IRAs are not always the best choice for everyone. In certain cases, contributing to a Roth IRA (which uses after-tax contributions but provides tax-free withdrawals) might make more sense. If you expect to be in a higher tax bracket in retirement or if you want to minimize your future tax liability, a Roth IRA might be more beneficial.

Additionally, if you have access to a 401(k) through your employer and you're eligible for Roth contributions or matching contributions, these options may be worth considering.

Pre-tax retirement accounts like traditional IRAs offer significant tax advantages today, but it’s important to keep in mind that the taxes are merely deferred until you begin making withdrawals. If you expect to be in a lower tax bracket when you retire, a pre-tax IRA can be an excellent tool for lowering your taxable income in the present while allowing your investments to grow tax-deferred. However, as with any financial strategy, it’s crucial to carefully consider your current financial situation, future expectations, and retirement goals before committing to any particular retirement plan.

As financial planners like Sarah H. suggest, “The decision to contribute to a pre-tax IRA should be part of a larger strategy. While the immediate tax savings are attractive, it’s essential to understand how these accounts will impact your retirement income and tax obligations down the road.”

By making the right choices and understanding how pre-tax retirement accounts work, you can set yourself up for a successful and tax-efficient retirement.