What Is an IRA?

Aim to be able to answer the "What is an IRA?" question if you want to retire comfortably.

May 18, 2014 at 11:30AM

While some financial experts are busy explaining how to invest in your IRA or whether you should convert your traditional IRA to a Roth IRA, many people are confused, because they're still wondering, "What is an IRA?"

Below are some simple answers to the "What is an IRA?" question.

For starters, an IRA is a tax-advantaged account that lets you save and invest for your retirement. There are two main types: the traditional IRA and the Roth IRA.

With a traditional IRA, you sock away money on a pre-tax basis, enjoying a tax break this year. For example, if you earn $50,000 and contribute $6,000 to a traditional IRA, that $6,000 is removed from your taxable earnings, leaving you with a smaller tax bill. If you're in a 25% tax bracket, you save $1,500 in taxes -- this year. Eventually, when you withdraw funds from the IRA in retirement, you'll be taxed on that money at your ordinary income tax rate, which might be lower then. (If you expect to be in a higher bracket in retirement, that's a good argument for a Roth IRA.)

A Roth IRA gives you no tax break now, but your earnings in it grow tax-free and all the money you withdraw from it later, if you follow the rules, will be tax-free!

There are other types of IRAs, too, for self-employed folks and owners of small businesses -- such as the SEP IRA and the SIMPLE IRA. Traditional and Roth IRAs have annual contribution limits of $5,500, plus an extra $1,000 for those 50 or older. SEP and SIMPLE IRAs have bigger limits.

Those are the basics about IRAs. There are more rules to them, though, such as that those in higher income brackets may not be permitted to make the full $5,500 or $6,500 contribution to a Roth IRA. Learn more before taking action. Once you're ready, you can compare IRA terms from some good brokers.

What's an IRA strategy?
Once you move beyond the "What is an IRA?" question, you might wonder, "What is an IRA strategy for me?" Learning more about IRAs will help you make the most of them. For example, if you're young, you might favor the Roth IRA. By starting young and making full contributions annually, you can build an IRA account worth hundreds of thousands of dollars -- or even a million or more by retirement -- and it will all be tax-free money.

Within a Roth, a good strategy is to invest in stocks that you expect will deliver above-average growth. A 10-bagger or 20-bagger will be much more powerful untaxed. 

Within a traditional IRA, dividend-paying stocks can be helpful if you don't want to have to sell off portions of your holdings in order to take the required minimum distributions in retirement. They could generate enough income for that. Dividends are also great for Roth IRAs, though, because you can ultimately collect them tax-free.

There's more to know as you answer the question, "What's an IRA?" But the bottom line is that an IRA can be a financial life-saver in this era of few pensions and great retirement uncertainty.

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.

Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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