There are plenty of IRA facts I could share with you that could help make the case why you should be using one. However, the most compelling reason to invest in an IRA is for the power of tax-deferred compound returns. Here's a discussion about why you should use an IRA to save for your retirement, and a chart that really shows the true potential of compound returns.
Why invest in an IRA?
An individual retirement account, or IRA, can be a great way to save for retirement, and could even save you money on your taxes this year.
IRAs come in two main varieties -- traditional and Roth, and the main difference is the tax advantages. Traditional IRA contributions may be tax-deductible in the year they're made, but eventual withdrawals in retirement will be taxable income. On the other hand, Roth IRA contributions aren't deductible, but any qualified withdrawals will be 100% tax-free. Of course, there's a little more to know about IRAs than I can explain in a paragraph, so here's an in-depth look to help you choose.
As of the 2016 tax year, you can contribute up to $5,500 to an IRA, and an additional $1,000 if you're over 50. If you have more than one IRA (such as a traditional and a Roth), your combined contributions cannot exceed these limits.
Even if you participate in a 401(k) or similar retirement plan at work, there are still some pretty compelling reasons to use an IRA. First of all, your 401(k) might not be enough, especially if you just contribute enough to get your employer's match. You may be surprised how much you'll need to save for a truly comfortable retirement -- even your 401(k) combined with Social Security might not provide sufficient income.
Next, there are some different rules about using IRA contributions before retirement age. For example, you can withdraw up to $10,000 penalty-free at any time to help pay for your first home, or any amount to help cover college expenses. Neither of these early withdrawals are permitted in a 401(k).
Finally, and perhaps most important, an IRA gives you more control over your retirement assets -- you can choose to invest in any stocks, bonds, or funds that you want. If you prefer to take a passive approach to investing, you can shop around for funds with lower fees than those in your 401(k). Or, if you want to pursue your own diversified stock portfolio, you're free to do that as well.
The most important IRA chart you'll ever see
Now, I'm a big advocate of buying individual stocks, as long as you have the time and desire to do it right. Having said that, to illustrate the amazing power of an IRA, let's look at a simpler example.
Warren Buffett has said many times that the best investment for most people is a low-cost S&P 500 index fund, and the Vanguard 500 Index Fund ETF (NYSEMKT:VOO) is a good one with a rock-bottom 0.05% expense ratio. Using this fund, which simply matches the market's performance, you may be surprised at how your investments can build over time.
Over the past 25 years, the S&P 500 has produced an annualized total return of about 9.4%. Assuming you contribute the maximum of $5,500 each year and your investment continues to grow at this rate, take a look at how your money could grow over time:
After 20 years, your contributions could produce an account value of more than $294,000. In 30 years, the power of compound returns could make your account swell to over $800,000, and in 35 years, you could be sitting on a $1.3 million nest egg. If you allowed your account to grow for even longer, well... you get the idea.
In other words, you could potentially start contributing to an IRA at age 30 and retire at 65 with $1.3 million. Using the conservative 4% rule of retirement, this translates to annual income of $52,000. This is in addition to your Social Security benefits and any income from a 401(k) or pension.
Of course, this is a simplification. In reality, this wouldn't be a smooth curve -- rather, there will almost certainly be ups and downs along the way. And, the maximum contribution of $5,500 will increase over time with inflation. However, the idea still applies.
The bottom line on IRAs
The point here is that an IRA is an amazing wealth-generating machine. The fact that by simply using the market's actual historic returns and contributions of $5,500 per year (about $460 per month) could allow you to retire as a millionaire just goes to show the importance of investing, and of starting as early as possible.
Matthew Frankel 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.