What is an IRA? Well, you might know it as a kind of retirement account, but you may not fully appreciate it. An IRA is a surprisingly powerful retirement account, able to transform a wobbly retirement into a solid one or an adequate retirement into a great one.
Nuts and bolts
Let's cover the basics of what an IRA is first. There are two main kinds of IRAs: the traditional IRA and the Roth IRA. Both limit you to $5,500 in contributions for 2015, plus $1,000 for those 50 and up. With a traditional IRA, you contribute money on a pre-tax basis, so the value of your contributions is subtracted from your taxable income, thereby reducing the tax you pay now. (For example, if your taxable income is $60,000 and you contribute $5,000, your taxable income falls to $55,000, shielding $5,000 from tax in your contribution year.) The money grows tax-deferred until you withdraw it in retirement, when it's taxed as ordinary income.
The Roth IRA, meanwhile, accepts only post-tax contributions, so you get no tax break up front. (Taxable income of $60,000 and contribution of $5,000? Your taxable income is still $60,000.) But if you follow the rules, it's withdrawn in retirement completely tax-free.
More powerful than a locomotive...
To appreciate just how much an IRA can improve your retirement, let's run through an example, assuming that you contribute $5,500 to a traditional IRA for 30 years, between age 35 and 65. If you invest well and the account's value grows by the stock market's long-term average annual growth rate of about 10%, you'll end up with ... (drumroll ...) $995,000! That's right – just about a million dollars from a rather modest annual investment.
It's true that you might not earn 10% annually. (An average annual growth rate of 8% will result in about $673,000, still a very meaningful and helpful sum.) But you'll probably increase your annual contribution as tax laws permit – at least, you should. And if you turn out to be an excellent investor, or just a lucky one, you might exceed the 10% growth rate.
Remember that your big traditional-IRA nest egg will eventually be taxed upon withdrawal. If it gets whacked with a 25% tax rate, you'd still be left with $746,000 (or $505,000 if your growth rate was 8%.)
And what would you walk away with if you'd made those annual $5,500 investments in a Roth IRA? Well, if the money grew at an average rate of 10%, that $995,000 would be all yours to keep -- tax-free! That's extremely hard to beat.
To roughly match the overall market's return, simply invest in low-cost, broad-market index funds, such as the SPDR S&P 500 ETF, Vanguard Total Stock Market ETF, and Vanguard Total World Stock ETF. Respectively, they distribute your assets across 80% of the U.S. market, the entire U.S. market, or just about all of the world's stock market. You can just leave your money in them for years.
Pros and cons of IRAs
Of course, IRAs have downsides along with their upsides. Let's review some of them.
On the plus side, you get tax advantages, whether upfront via the traditional IRA or deferred via the Roth IRA. They're easy to set up at any reputable brokerage and many other financial companies. And they offer a wide range of investment options, such as stocks, bonds, mutual funds, and CDs, giving you a lot of choice and control. (With 401(k)s, you're typically limited to a bunch of mutual funds.)
On the other hand, your annual contribution limits are a bit on the small side, at least compared with 401(k)s, which have hefty double-digit limits. 401(k)s will also often matching contributions from your employer – that's free money. The limits for tax-advantaged contributions to IRAs shrink to zero, too, for high earners. And just like 401(k)s, traditional IRAs feature penalties if you withdraw money early. (Note that you don't even have to choose between them. You can fund both an IRA and a 401(k).
The benefits of IRAs outweigh their disadvantages. Social Security may be a great help in retirement, but the average retirement benefit is only about $16,000 per year. IRAs can make your financial future much brighter.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, 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.