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How an IRA Account Helps You Today, and Not Just in Retirement

If you've been hearing rumors about your neighbor or co-worker's IRA account, then let me set the record straight: They're probably true. In short, there are few things as advantageous to the average American as an individual retirement account sanctioned by the IRS.

Why you should have an IRA today
In short, virtually every working American would benefit from having an IRA. And the best news is that they're easy to understand and can increase your tax refund by more than $1,000 a year. For fear of getting ahead of ourselves, however, let's start with the basics.

IRA stands for "individual retirement account." In many ways these are indistinguishable from a standard savings account. Most banks and discount brokerages offer them. Their purpose is to store your money until future use. And, within predefined limits, they can be added to at your leisure.

The biggest difference is that once money is deposited into the account it can't be withdrawn absent a stiff penalty until you turn 59.5 years old. In this respect, an IRA serves as a way to gently cajole Americans into preparing for retirement.

Now, just to be clear, there are two general types of IRAs. The first is a Roth IRA, which allows your contributions to grow tax-free even once you withdraw them -- this, of course, is assuming you invest the funds. And the second is a traditional IRA, which is what we're interested in here.

A traditional IRA is particularly attractive because it allows you to deduct the contributions from your income taxes in the current year up to a maximum of $5,500 -- an important caveat is that the deduction is gradually phased out for single individuals who earn more than $112,000 and married people filing jointly with a combined income of $178,000.

An example of how an IRA can save you money
By way of example, let's assume Stephen earns $60,000 in taxable income working as a machine engineer in a local equipment factory. If he's single and doesn't qualify for any other credits or deductions, Stephen would end up owing the federal government $10,856 in income taxes.

By contrast, now let's assume Stephen contributes $5,500 to a traditional IRA, which is equal to the 2014 limit. By doing so, he reduces his taxable income to $54,500 and thereby drives his income tax liability down to $9,481.

Income Tax Line Item

Without IRA Contribution

With Traditional IRA Contribution of $5,500

Gross Income

$60,000

$60,000

Taxable Income

$60,000

$54,500

Tax Bill

$10,856

$9,481

Savings

$0

$1,375

Excluding the impact of unrelated credits and deductions. Source: author.

The immediate benefit to Stephen, in other words, is a $1,375 cut to his tax bill; another way to look at this is that it adds a comparable amount to your refund if taxes are automatically withheld from your paycheck.

Taking this one step further, moreover, if you compare the $1,375 figure to the amount set aside -- i.e., $5,500 -- then Stephen effectively achieved a single-year return on investment of 25%, or nearly triple the long-run average of the S&P 500 (SNPINDEX: ^GSPC  ) .

The point here is that an IRA account -- and, specifically, a traditional IRA -- is effectively free money. Or, at least, it's the closest thing to free money that most of us are likely to ever come across.

How to get even more income during retirement
Social Security plays a key role in your financial security, but it's not the only way to boost your retirement income. In our brand-new free report, our retirement experts give their insight on a simple strategy to take advantage of a little-known IRS rule that can help ensure a more comfortable retirement for you and your family. Click here to get your copy today.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 18, 2014, at 6:52 PM, aaronmarks42 wrote:

    An IRA is an important tool for retirement savings, but it should be addressed that a Roth IRA may be more valuable for people in lower tax brackets, who can expect to pull money out at retirement when taxes are higher. A retirement plan needs to be multi pronged, and other assets could fill the need of an IRA such as a 401K, and also it may get a matching salary contribution from your employer. These are the most important things I learned were essential for a good retirement plan:

    1. Invest in diversified low cost funds such as Vanguard. Match your investment mix to your age and risk tolerance. I am about 70%equities and 30% fixed income.

    2. Get life insurance. Stay away from expensive whole life insurance. Get term life from a place like LifeAnt for about $20 a month. Watch Suzey Orman or Dave Ramsey sometime if you have not heard of buying term and investing the difference.

    3. Set up a revocable trust for a tax efficient transfer of assets.

    4. Put at least the maximum amount in your 401k that your employer will match.

    5. Save between 10-15% of your income every year for retirement in total.

    These are just the basics but they have really helped me.

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John Maxfield
JohnMaxfield37

John has been writing for The Motley Fool since 2011. As a senior banking analyst, he covers the financial industry and the nation's largest banks in particular. He has a bachelor's degree in economics from Lewis and Clark College and a juris doctorate from Southern Methodist University. He's a licensed attorney in the state of Oregon, and resides in Portland with his wife and twin sons. View John Maxfield's profile on LinkedIn

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