The short answer to this question is "yes." The average American would benefit tremendously from using an individual retirement arrangement, or IRA, to save for retirement. However, only 18% of American adults are actively contributing to an IRA, according to a TIAA survey. To be fair, some Americans are not qualified to contribute to an IRA thanks to income limitations, but this percentage is still shockingly low.
If you're a member of the majority of Americans who doesn't currently use an IRA to save and invest for retirement, you may change your mind when you see the tax advantages and, more importantly, the long-term benefits of using an IRA.
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How IRAs work
IRAs are tax-advantaged accounts designed to help Americans save and invest for retirement. Money contributed to an IRA can be invested in virtually any stocks, bonds, or funds you want. The idea is that over time, your investments can grow into a hefty retirement nest egg.
There are two main varieties of IRA -- traditional and Roth. The main difference is the tax structure, which I'll get more into in a bit, but in both cases, your investments are free to grow and compound without paying taxes on dividends or capital gains. There are some other differences between traditional and Roth IRAs, so read this primer to determine which could be the better fit for you.
As of the 2017 tax year, Americans who qualify can contribute up to $5,500 to their IRA, with an additional $1,000 catch-up contribution allowed for savers over 50.
Why the average American should use an IRA
Simply put, Americans as a whole are doing a poor job of saving for retirement. The average American with a 401(k) has a balance of $92,500, and while this is an all-time high, it's nowhere near enough to provide enough income for a comfortable retirement that could last for decades.
Even older Americans are woefully underprepared. About half of baby boomers have $100,000 or less set aside for retirement (including 401(k)s, IRAs, and other types of retirement account), and one-third have less than $50,000. Saving and investing regularly in an IRA could provide a big boost to these numbers.
Tax advantages
There are a couple of big tax advantages to investing in an IRA. Both Roth and traditional IRAs allow your money to grow without capital gains or dividend taxes. Roth IRAs don't qualify for an immediate tax deduction, but your qualified withdrawals after retirement will be tax-free. Traditional IRA contributions also can be tax deductible, but eventual withdrawals will be considered as taxable income.
Let's use the traditional IRA example to illustrate how IRA investing could help American households save money.
The average married couple filing a joint tax return has an adjusted gross income of $117,795, according to the latest IRS data. Assuming the standard deduction and four exemptions (two spouses and two children), this would translate to a taxable income of $88,895, which would put the average married couple filing a joint tax return in the 25% tax bracket.
Also, keep in mind that the traditional IRA deduction can be taken regardless of whether you itemize or use the standard deduction. Since the maximum traditional IRA contribution is $5,500 per person under age 50, if both spouses contributed the maximum, it would reduce their taxable income by $11,000. This would save the average American married couple $2,750 on their 2017 tax bill.
Furthermore, lower-income taxpayers may qualify for the Saver's Credit, in addition to the other tax benefits. This can be worth up to $1,000 per person for married couples earning $61,500 or less or singles earning $30,750 or less in 2017.
The long-term benefits can be fantastic
While the tax benefits I discussed in the previous section are certainly nice, the real reason to invest in an IRA is for the long-term effects of compound investment growth.
Consider this example: Let's say that you open a traditional IRA when you're 30 and contribute $5,000 per year, for a total contribution of $150,000. Assuming 8% average investment returns, which is in line with historical market performance, your account could be worth $935,000 by the time you're 65.
What's more, if you invested in a traditional IRA, you would have saved yourself $1,250 every year on your tax bill, assuming the 25% tax bracket. In a Roth IRA, you would now be free to withdraw from this nest egg tax-free -- you wouldn't have to pay a dime in taxes on your $785,000 profit.
The real question: How to invest in your IRA
If you haven't yet noticed, the answer to "Should the average American use an IRA?" is a resounding "yes!"
The next step is figuring out how to invest once you start investing in an IRA, by familiarizing yourself with some basic asset allocation principles and some good examples of stocks that work well in IRAs.
