In all likelihood, you will receive Social Security benefits when you retire. However, Social Security will probably cover only half of your needs—possibly less, depending upon your retirement lifestyle. You’ll need to make up this shortfall with your own retirement investments.
The best way to do this is to set up one or more tax-deferred retirement accounts. You can deduct the amount you contribute to such accounts. Moreover, you do not pay taxes on investment earnings from retirement accounts until you withdraw the funds. Because most people withdraw these funds at retirement, they are often in a lower income tax bracket when they pay tax on these earnings. This can result in substantial tax savings for people who would have had to pay higher taxes on these earnings if they paid as the earnings accumulated.
The simplest type of tax-deferred retirement account is the individual retirement account, or IRA. An IRA is a retirement account established by an individual, not a business. You can have an IRA whether you’re a business owner or an employee in someone else’s business.
An IRA is a trust or custodial account set up for the benefit of an individual or his or her beneficiaries. The trustee or custodian administers the account. The trustee can be a bank, mutual fund, brokerage firm, or other financial institution (such as an insurance company).
IRAs are extremely easy to set up and administer. You need a written IRA agreement but don’t need to file any tax forms with the IRS. The financial institution you use to set up your account will usually ask you to complete IRS Form 5305, Traditional Individual Retirement Trust Account, which serves as an IRA agreement and meets all of the IRS requirements. Keep the form in your records—you don’t file it with the IRS.
Most financial institutions offer an array of IRA accounts that provide for different types of investments. You can invest your IRA money in just about anything: stocks, bonds, mutual funds, treasury bills and notes, and bank certificates of deposit. However, you can’t invest in collectibles such as art, antiques, stamps, or other personal property.
You can establish as many IRA accounts as you want, but there is a maximum combined amount of money you can contribute to all of your IRA accounts each year. This amount goes up with inflation in $500 increments. Currently, people under 50 years of age may contribute $5,500 each year (2014 and 2013), while those over 50 can contribute an additional $1,000 (in 2014 and 2013). This rule is intended to allow older people to catch up with younger folks, who will have more years to make contributions at the higher levels.There are two different types of IRAs that you can choose from:
- traditional IRAs, and
- Roth IRAs.
Traditional IRAs have been around since 1974. Anybody who has earned income (from a job, business, or alimony) can have a traditional IRA. You can deduct your annual contributions to your IRA from your taxable income.
If neither you nor your spouse (if you have one) has another retirement plan, you may deduct your contributions no matter how high your income is. However, there are income limits on your deductions if you (or your spouse, if you have one) are covered by another retirement plan.
You may not make any more contributions to a traditional IRA after you reach age 70½. Moreover, you’ll have to start making distributions from the account after you reach that age.
There are time restrictions on when you can (and when you must) withdraw money from your IRA. You are not supposed to withdraw any money from your IRA until you reach age 59½, unless you die or become disabled. Under the normal tax rules, you are required to start withdrawing at least a minimum amount of your money by April 1 of the year after the year you turn 70. Once you start withdrawing money from your IRA, the amount you withdraw will be included in your regular income for income tax purposes.
As a general rule, if you make early withdrawals, you must pay regular income tax on the amount you take out, plus a 10% federal tax penalty. There are some exceptions to this early withdrawal penalty (for example, if you withdraw money to purchase a first home or pay educational expenses, the penalty doesn’t apply—subject to dollar limits).
Like traditional IRAs, Roth IRAs are tax-deferred and allow your retirement savings to grow without any tax burden. Unlike traditional IRAs, however, your contributions to Roth IRAs are not tax-deductible. Instead, you get to withdraw your money from the account tax-free when you retire.
Once you have established your account, your ability to contribute to it will be affected by changes in your income level. You can withdraw the money you contributed to a Roth IRA penalty-free anytime—you already paid tax on it so the government doesn’t care. But the earnings on your investments in a Roth IRA are a different matter. You can’t withdraw these until after five years. Early withdrawals of your earnings are subject to income tax and early distribution penalties. You are not, however, required to make withdrawals when you reach age 70½. Because Roth IRA withdrawals are tax-free, the government doesn’t care if you leave your money in your account indefinitely. However, your money will be tax-free on withdrawal only if you leave it in your Roth IRA for at least five years.
Is the Roth IRA a good deal? If your tax rate when you retire is higher than your tax rate before retirement, you’ll probably be better off with a Roth IRA than a traditional IRA because you won’t have to pay tax on your withdrawals at the higher rates. The opposite is true if your taxes go down when you retire. The catch is that nobody can know for sure what their tax rate will be when they retire.