IRA Benefits: They Can Turbocharge Your Retirement

I remember very vividly -- I wrote about it in one of my books -- my first IRA. I contributed $2,000 every year, and in 21 years, the funds in that IRA account grew to $260,000. Seems like sort of a miracle, but it happened.

-- Charles Schwab

It's easy to get confused in the world of IRAs. There are Roth IRAs and traditional IRAs, Fidelity IRAs and Vanguard IRAs (among many others). But just what is an IRA? What do the three letters stand for, and what do they mean for your retirement? Let's define some terms and get to know IRAs better -- because they can be powerful retirement-savings aids.

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The IRA defined -- here's what the I, R, and A stand for

Many people assume that the letters IRA stand for "Individual Retirement Account." That makes sense, as IRAs are individual retirement accounts. But when the IRA was born, it was officially named the Individual Retirement Arrangement. Its official name doesn't matter much, though. What really matters is what an IRA can do for you.

Traditional and Roth IRAs

Let's first review just what IRAs are and how they work. There are two main kinds of IRAs -- the traditional IRA and the Roth IRA. With a traditional IRA, you contribute pre-tax money, reducing your taxable income for the year, and thereby reducing your taxes, too. (Taxable income of $70,000 and a $5,000 contribution? Your taxable income shrinks to $65,000 for the year.) The money grows in your account and is taxed at your ordinary income tax rate when you withdraw it in retirement. Many of us will be in lower tax brackets in retirement, so not only is our tax bill postponed, but it's often reduced as well. That's the tax break you get with a traditional IRA.

A Roth IRA, on the other hand, has the potential to be much more powerful. You contribute post-tax money to a Roth IRA, so your taxable income isn't reduced at all in the contribution year. (Taxable income of $70,000 and a $5,000 contribution? Your taxable income remains $70,000 for the year.) Here's why the Roth IRA is a big deal, though: If you follow the rules, your money grows in the account until you withdraw it in retirement -- when it's yours tax-free.

Here are some additional benefits: Roth IRAs let you contribute after age 70 1/2, unlike traditional IRAs. Your Roth contributions (but not their earnings) can be withdrawn at any time, penalty-free, though it's best to leave them in place and growing for a long time. You can withdraw earnings from a Roth or traditional account once you have had it for five years and hit age 59 1/2. Traditional IRAs require you to start taking required minimum distributions at age 70 1/2, but Roth IRAs don't require you to withdraw anything in your lifetime -- you could choose to just leave the money to your heirs.

Both kinds of IRAs offer this benefit in retirement: If you want to delay starting to collect Social Security benefits so that your benefit checks will be bigger, you may be able to do so by withdrawing more heavily from your IRA account(s) in your early retirement years. Both also permit withdrawing up to $10,000 from your account early, in order to buy a first home, if you follow a few rules.

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Contribution limits for your IRA accounts

So how much can you sock away in an IRA? Well, IRA contribution limits for the 2017 and 2018 tax years are the same -- $5,500 -- with people aged 50 and older allowed an extra $1,000 "catch-up" contribution, giving them a maximum of $6,500 for the year. Note that the limit is a total limit, for any and all IRA accounts you might have. If you have three IRAs, you can contribute $5,500 or $6,500 to just one, or you can distribute the amount among two or more of your IRAs.

For best results when saving for retirement with an IRA, contribute as much as you can -- and as soon as you can. The longer your money has to grow, the more it can grow. Imagine, for example, that you contribute $4,500 every year for 25 years to an IRA and it grows at 8% annually. That will eventually amount to about $355,000 -- which is pretty good. But if you had contributed $5,500 annually (just $1,000 more) and it all grew at 8% per year, the end result would be $434,000 -- a difference of $79,000!

Of course, the annual contribution limits are increased from time to time, and once you reach age 50 you can sock away more, so to get the most out of your account, aim to contribute as much as you can each year. The table below shows how much money you can accumulate with annual $5,500 contributions at different average annual rates of growth:

Data source: Calculations by author.

Many of the sums above would be very welcome when you retire, right? Remember that when you withdraw funds from them in retirement, they would be taxable income if they were in a traditional IRA, but they would be all yours with no taxes due if they were in a Roth IRA.

The table above shows you an IRA's main benefit: allowing you to accumulate significant sums in a tax-advantaged way. If you sock away $5,500 annually for 20 years and you average 10% annual growth, you'll end up with roughly $346,000. And that's from having contributed a total of $110,000 over the years into the account. Your money would have grown, giving you an additional $236,000.

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What kind of IRA account should you open?

If you're wondering what kind of account to open, you might want to first decide whether you want a traditional or Roth IRA. (You might conceivably want one or more of each, actually, which is OK.) Beyond that, just remember that all IRA accounts of the same type will generally conform to the same rules, no matter whether they're Fidelity IRAs or Vanguard IRAs or IRAs from your local bank. Your contribution limits, for example, will be the same no matter which provider you choose. You'll have to start required minimum distributions (RMDs) at age 70 1/2 with any traditional IRA account.

But still, it can matter where you open your IRA. Many financial-services companies, such as brokerages, banks, and mutual fund companies, offer IRAs. You might prefer a particular company for any of a number of reasons. If you do a lot of business with one company and like it, you might want to stick with it. Having several different accounts at one institution can make it extra easy to move money between accounts when you want to -- such as if you want to fund your IRA with money from a brokerage or bank account.

While retirement accounts such as 401(k)s and 403(b)s tend to offer you a limited menu of investment options, such as a handful of mutual funds, IRAs can be much more liberal. An IRA opened through your brokerage will let you invest in just about any stock through it, as well as any of hundreds or thousands of mutual funds the brokerage offers. Opening your IRA account with a particular mutual fund company, though, can limit you to only the funds of that company. Of course, that can be OK, as one (or a few) simple and inexpensive index fund(s) could be all you need.

As you're considering contenders for your business, check out each provider's minimum initial investment. Some will have no minimum amount at all, while others might require at least $1,000 or more. Finally, consider fees and trading commissions. These days it's common to see financial-services companies charging commission fees of $10, $7, $5, or less each time you want to buy or sell shares of a particular stock. If you expect to do a lot of trading, you'll want to choose a provider with very low commission rates. If you'll trade infrequently, which is generally best, you don't necessarily need the lowest trading fees.

The benefits of an IRA are significant, making it a no-brainer for many people to open and use one or more accounts. Here's one last wonderful thing about IRAs: Their contribution deadlines are not at the end of the year. Each tax year's contributions can be made until the regular deadline for filing your tax return. So for most tax years, the deadline is April 15 of the following year. (Be sure to write on your check or otherwise specify which year a contribution is for.)

For the 2017 tax year, contributions are due by April 17 of 2018. In other words, there's still plenty of time to make your 2017 contribution -- and your 2018 one, too!