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. People over 50 years old can contribute an extra $1,000 per year to allow them to catch up with younger folks who will have more years to make contributions at the higher levels.
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 70