An Individual Retirement Account is a personal savings plan that allows you to contribute up to $4,000 a year in a tax-advantaged way. (If you're 50 or older, you can make an additional $500 "catch-up" contribution.) The limit is currently scheduled to increase incrementally, hitting $5,000 in 2008.
With a traditional IRA, you're permitted (if you qualify) to sock away a certain amount each year, tax-deferred. The tax deferral is an important aspect of this kind of account. If you earn $40,000 per year and you contribute $4,000 to an IRA, that $4,000 is deducted from your income and you're not taxed on it -- that year. It's as though your income were $36,000 instead of $40,000 that year. This means that in the year that you contribute $4,000, if you're in a 27% tax bracket, you don't have to pay $1,000 (25% of $4,000). If that $1,000 were plunked into the stock market and grew at the historical average rate of 10%, it would grow to $6,728 in 20 years ($17,450 in 30 years). Traditional IRA contributions are taxed upon withdrawal.
Meanwhile, there's a (somewhat) new IRA beast in town -- the Roth IRA. With Roth IRAs, the money you contribute is post-tax. So if you earn $40,000 this year and contribute $4,000 to a Roth IRA, you don't reduce your taxable income to reflect the contribution. There's no upfront tax benefit. But there is a tax benefit upon eventual withdrawal of money from the account, and it can be a big one. The funds are withdrawn tax-free! So if you invest $4,000 and in 20 years it grows to $28,000, your $24,000 gain is not taxed. You get access to all the money.
There are a bunch of additional important things to know about both traditional and Roth IRAs -- learn more about whether you qualify to use them and how you should best use them. You can get the basics in our IRA Center and via our 60-second guide to opening an IRA.
Learn more about retirement issues in our Retirement area. We've got 401(k) and annuity information available, too. To learn to more about brokerages and possibly find a better brokerage for yourself, check out our Broker Center.
More from The Motley Fool
Will 2018 Be Canadian Solar Inc.'s Best Year Yet?
Canadian Solar's future is bright, but it may not be public long enough to show its true potential.
What Would Happen if Your Car Could Read Your Mind?
If it’s up to Nissan, we may soon find out.
How Axon Enterprise Can Become a Home Run Stock in 2018
If the taser and body camera company's management can get its finances in sync with its growth, this laggard could rapidly become a winning stock for investors.