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What the Fool Is an IRA?

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What is an IRA? Short for "individual retirement account," an IRA lets you save and accumulate money for your golden years -- and pay less in taxes in the process. Uncle Sam created the IRA in 1974 to encourage more people to save for retirement.

What can I put in an IRA? Just about anything, financially speaking. You can stuff your IRA with stocks, bonds, exchange-traded funds, mutual funds, even cash. (Although we wouldn't recommend that last one for the long term, unless you like losing purchasing power to the steady creep of inflation.)

How is an IRA different from a regular brokerage account? In a regular account -- the kind you might set up with your bank or an online broker -- you'll pay taxes on any gains you make from selling your holdings, and every time a stock, fund, or ETF pays you dividends. With an IRA, as long as the money stays in your account, the tax man can't touch it.

But wait, there's more! IRAs come in two flavors, and each offers you an additional tax benefit:

  • Traditional: The money you put into your IRA each year reduces your taxable income. If you make $40,000 in a year, and contribute $5,000 to a traditional IRA, you'll only pay taxes on $35,000 of what you made. When you take money out of a traditional IRA in retirement, it'll be taxed as ordinary income, like a paycheck.
  • Roth: You don't get any up-front reduction in your taxable income -- but when you reach retirement, you can withdraw money from your IRA without paying a dime in taxes on it.

Sounds great! What's the catch? First, you can't shovel huge piles of money into your IRA. For 2010, folks under 50 can only contribute $5,000 a year to an IRA; anyone 50 and over can add an extra $1,000 to that amount.

Second, once you put money into a traditional IRA, you usually can't start withdrawing it until you reach age 59 1/2 without incurring taxes and additional penalties. (Yeah, we don't know what's up with the half-year, either.) Roth IRAs have more complicated rules that give you somewhat more access to your money, but it's generally best not to withdraw from either type of IRA prior to retirement age if possible.

Third, with a traditional IRA -- but not a Roth -- you'll have to start taking money out by age 70 1/2, if you haven't already.

Finally, with a Roth -- but not a traditional IRA -- the amount you're allowed to contribute each year begins to dwindle to nothing as your annual income passes a certain threshold. For 2010, the line begins at $105,000 (for single folks) or $167,000 (for spouses filing jointly).

What investments are best for an IRA? For starters, you'll want to fund your IRA with money you won't need to touch until you hit retirement age. If you'd like to put money in the stock market to pay for college, fund a down payment on a house, or just get filthy rich and buy a gargantuan yacht, stick with a regular brokerage account.

Beyond that, IRAs are great for investments that would otherwise leave you with a big tax bill:

  • Growth stocks: If that tech company you bought when it was just a start-up shoots to the moon, you'll be on the hook for taxes on its staggering gains when you finally cash out. In an IRA, stocks can grow tax-free.
  • Dividend stocks: Like we said earlier, every time a stock or fund pays you a dividend, Uncle Sam wants his cut. In an IRA, you can pile up those dividends -- and reinvest them into more shares, which will pay you even more dividends -- without the IRS butting in.
  • High-turnover mutual funds: If the managers of your mutual fund buy and sell their holdings frequently, they have to pay taxes on the gains from those sales, same as everyone else. But in this case, they're only too happy to pass those expenses on to you. An IRA can shield you from paying their tax bill.

Where can I set up an IRA? Any of the major online brokers will be only too happy to take your money. Most mutual fund companies can also set up an IRA for you. In some cases, even your regular bank may be able to help you out.

Sounds great! Where can I learn more? Hop over to our IRA Center to get all the individual-retirement-account-y goodness you could ever want.

Fool online editor Nathan Alderman's dad helped him start an IRA at age 18. Thanks, Dad. The Fool has a disclosure policy.


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Nathan Alderman
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Nathan Alderman is a longtime Fool who lives in Crozet, Va.

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