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What Is an IRA and Why Do You Need One?

Two things the most successful investors take advantage of are the time and tax advantages they're entitled to. For individual investors, there's no better way to do this than by opening an IRA. But what is an IRA, and how can you get started? Here's an overview of the two basic types of IRA accounts and the benefits of each.

Photo: 401(k) 2012 via Flickr.

What is an IRA?
An individual retirement account, or IRA, is a special type of account designed to help American investors build money for their retirement. There are two main types of IRA accounts, Roth and traditional, and both have their benefits and drawbacks, with the main difference being the tax treatment.

These two IRAs have some things in common. They have the same contribution limits, currently $5,500 per year (or $6,500 if you're over 50, to let you "catch up"). This contribution amount can be used entirely on one type of account or split between both -- e.g., you can put $3,000 in a Roth IRA and $2,500 in a traditional IRA.

Further, both accounts are allowed to grow tax-free until you withdraw money. In both accounts, you have to wait until age 59-1/2 to withdraw your investment returns without facing an early-withdrawal penalty. There are some exceptions, though, like the ability to withdraw up to $10,000 toward a down payment on your first home.

Roth IRAs are great, if you qualify
A Roth IRA basically allows you to contribute money that you've already paid taxes on; it then allows that money to grow tax-free until retirement. When you've reached retirement age, you can withdraw the money tax-free, which could save you hundreds of thousands of dollars in potential tax liability down the road.

Roth accounts are also great for people who may need to access their money before retiring. One of the most appealing features of a Roth IRA is that it doesn't necessarily tie up your money until retirement. You're allowed to withdraw your contributions (but not any gains) penalty-free at any time.

However, not everyone qualifies for a Roth IRA. In order to be eligible to make a full contribution to a Roth IRA, you need to earn less than $114,000 per year ($181,000 for married couples), and eligibility phases out entirely for incomes higher than $129,000 ($191,000 for married couples) for the 2014 tax year. If you are under the income cap, you can make a full contribution to a Roth account, whether or not you participate in a retirement plan at work.

There are ways around the income limits, however. In a strategy known as the "backdoor" to a Roth IRA, anyone, regarless of income level, can contribute to a traditional IRA, then convert the account to a Roth IRA, so long as they pay taxes on any pretax funds contributed to the original traditional account.

Traditional IRAs save now, but you'll pay later
Although everyone can qualify for a traditional IRA, not everyone can use the full tax benefit. If you are covered by a retirement plan at work, the full immediate tax benefit is only useful if you make less than $60,000 ($96,000 for married couples who are both covered, and $181,000 when one spouse is covered under an employer's plan). If you earn below this amount, any contributions to a traditional IRA are tax-deductible. In other words, you don't pay taxes on that portion of your income that year.

However, it'll cost you down the road. Your deposits are allowed to grow and compound on a tax-deferred basis, but your distributions, once you retire, will be taxed as ordinary income. Plus, a traditional IRA doesn't allow you to withdraw your principal without penalty before retirement.

There are other drawbacks of a traditional IRA as well. For instance, a Roth IRA doesn't have any requirement to take distributions by a certain age, whereas traditional IRA rules mandate distributions by age 70-1/2, lest the IRS can assess a penalty.

Which should you choose?
To help decide what's best for you, let's look at three avenues for investing $5,500 per year for 30 years: a Roth IRA, a traditional IRA, and a standard, taxable brokerage account. For simplicity's sake, let's say your portfolio earns 5% dividends and the value of your investments also rises by 5% per year, for total annual returns of 10%.

First, let's simply compare an IRA to a taxable account:

30-Year Performance: IRA vs. Taxable Account | Create Infographics.

Either IRA choice is obviously better than the taxable account. Not only will the taxable account be worth less due to your dividends being taxed every year, but you'll have to pay taxes when you withdraw your money. If you're in the 25% tax bracket, this makes your $716,000 portfolio effectively worth just $537,000 -- and that's not including state income taxes.

For the traditional IRA, your money compounds on a tax-deferred basis, but you pay taxes on withdrawals, which makes your $905,000 portfolio worth less than $679,000 after taxes.

With the Roth IRA, you have to pay tax on your income before you contribute, so your $5,500 annual allocation for retirement savings really becomes an after-tax contribution of $4,125, assuming you're in the 25% tax bracket. Compounded the same way as the chart above, the Roth account after 30 years with $4,125 annual contributions would have an ending value of about $679,000 -- the same as the "real" value of the traditional IRA. It's just a question of whether or not you want the tax benefit now or down the road.

Invest early and often
Even if you have an employer-sponsored retirement plan, such as a 401(k) or a pension plan, an IRA is still a good investment choice, and it allows you to take more control over your own retirement. Chances are that the amount of money in those accounts won't be enough to provide you with total financial security, and the benefits of investing in an IRA are so great that it's a no-brainer to use one to supplement your current retirement savings.

Some fine choices for your IRA
The smartest investors know that dividend stocks simply crush their non-dividend-paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

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Matthew Frankel

Matt brought his love of teaching and investing to the Fool in order to help people invest better, after several years as a math teacher. Matt specializes in writing about the best opportunities in bank stocks, real estate, and personal finance, but loves any investment at the right price. Follow me on Twitter to keep up with all of the best financial coverage!

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