Here's an easy question for you: Would you like to retire someday?
Now here's a tougher question: Do you know how an IRA works?
If you answered "yes" to the first question, then you should also be able to answer "yes" to the second one. In fact, you should learn just about everything there is to know about IRAs, or individual retirement accounts. These simple, easy-to-open accounts reward retirement savers with major tax breaks.
Unfortunately, a January 2017 TIAA IRA survey revealed that the majority (65%) of Americans do not have an IRA. Of those, 28% said they don't know enough about IRAs, and another 17% said IRAs are too complicated. If the only thing stopping you from taking advantage of this powerful savings tool is a lack of knowledge, then stick around to see how simple it is to change your financial picture.
First, you should know that there are two main types of IRAs: traditional and Roth. You can choose either or both. For 2017, you can contribute the lesser of your annual earned income or $5,500 if you are under age 50. If you are aged 50 or older, you can contribute the lesser of your annual earned income or $6,500.
Regardless of how many accounts you have or what type they are, you can split the contribution however you'd like between the accounts -- you just can't exceed the maximum allowable amount. And generally, any time you withdraw money from an IRA before age 59-1/2, you will face some sort of penalty unless you qualify for an early withdrawal exception (after all, the government created these accounts to reward Americans for saving for retirement). More on that below.
What really separates an IRA from a regular brokerage account is the preferential tax treatment that IRAs are afforded: Money inside any IRA can grow untaxed for decades.
But here's where the traditional and Roth operate differently.
A traditional IRA
Anyone with taxable income can contribute to a traditional IRA, and anyone who meets certain requirements can deduct those contributions from their taxable income in the current tax year.
If you make deductible contributions, meaning you deposit untaxed money into the account, your money can be shielded from taxes until you begin taking distributions, at which time you will owe ordinary income taxes on both principal and any earnings.
If, on the other hand, any or all of your contributions were nondeductible, meaning you deposited after-tax dollars into the account, then that money will not be taxed again when you take it out. However, any earnings on that money will be subject to ordinary income taxes when they are distributed from the account.
Generally, the government requires you to start taking minimum distributions from your traditional IRA at age 70 1/2, at which point you can no longer contribute to the account even if you are still earning income.
A Roth IRA
Not everyone can directly contribute to a Roth IRA, as there are income limits on who can fund a Roth IRA. However, even if you exceed those income limits, there is a loophole in the law that allows high-earning individuals to contribute through what's referred to as the "backdoor."
Regardless of how you get your money into a Roth, all Roth IRA contributions are made with money that has already been taxed. Because you're putting after-tax dollars into the account, any money you contribute to the account can be withdrawn tax- and penalty-free at any time. (Note that any converted contributions must remain in the account for five years before you can withdraw them penalty-free.)
When you take qualified distributions from a Roth IRA (generally, after you are 59 1/2 and have had a Roth IRA for at least five years), any account distributions, including your original after-tax contributions plus any earnings you've made, will all be tax-free. And while you are required to begin drawing down your assets from a traditional IRA because you owe income taxes on that money, you are never required to begin taking distributions from a Roth IRA; your funds can grow untaxed for your lifetime. Additionally, as long as you have earned income, you can continue contributing to the account even past age 70 1/2.
Open an IRA today and invest for your future
Finally, it's important to understand that an IRA is not an investment; it's an investment account. To be more specific, it's a retirement savings vehicle that can hold your investments and is earmarked for long-term savings. You can set up an IRA at various financial institutions, like a discount brokerage firm or even your bank.
An IRA can help you with two main investing components: keeping your fees low and diversification. Unlike a workplace 401(k) or 403(b), where you usually have a limited menu of pre-selected investments and no control over costs and fees, an IRA gives you unlimited access to investments, including low-cost ETFs and mutual funds, which can give you immediate and broad diversification. You can further diversify your portfolio with alternative investments that you may not have access to in a workplace retirement plan, such as real estate and gold funds, among many others.
Remember: All of your retirement accounts are part of one portfolio. You can directly contribute to an IRA, and you can also roll money from old workplace retirement plans into an IRA. And if you have a retirement account at work, you can use an IRA to work in conjunction with it.
Everyone needs to save for their own retirement. And retirement accounts will comprise a large portion of your wealth -- and they will perhaps be one of the most valuable financial tools you have as you spend decades saving for one of your most important life goals: living the retirement that you've dreamed of.
The Motley Fool has a disclosure policy.
More from The Motley Fool
No Holiday Reprieve for 2 of the Biggest Retail Train Wrecks
Most department store chains have posted surprisingly strong results for the 2017 holiday season. However, these perennial laggards couldn't capitalize on the uptick in consumer spending.
3 Stocks That Could Put Amazon's Returns to Shame
These three tickers could be better bets than Amazon for new investors right now.
Will This iPhone Supplier’s Terrific Run Continue in 2018?
Lumentum's growing momentum in 3D sensing could help it overcome the weakness in the telecom segment.