Let's start with the basics. "IRA" is an abbreviation for "individual retirement arrangement" or "individual retirement account," depending on whom you ask. Now, did you know there are two different kinds of IRA? There's the traditional one, and there's the Roth IRA. Either one can serve you very well as you diligently sock money away for retirement.
Here's how the traditional IRA works. This year, you can contribute up to $4,000 (if you meet certain qualifications) or $4,500 if you're 50 or older. Do so, and the amount you contribute is deducted from your income and therefore isn't taxed. If you're in the 25% tax bracket, contributing $4,000 will knock $1,000 off your taxes in 2005. You'll eventually be taxed on the IRA money when you begin withdrawing it -- but that's much later, after it has had a chance to grow in a comfy, tax-deferred environment.
The Roth IRA is even more compelling for most of us. Yes, you plunk post-tax money into it, so you get no upfront tax benefit. But for fans of delayed gratification, things can't get much more enticing -- the money you eventually withdraw will be tax-free. So imagine that you opened a Roth IRA account (which you can do at most brokerages -- we can help you find one that charges very low commissions) and invested $4,000 in eBay (NASDAQ:EBAY) stock. That stock has more than tripled over the past five years. Let's say that it increases in value tenfold over the next 20 years (that's roughly 12% annual growth), leaving you with $40,000 in your IRA. If your gain of $36,000 were taxed at current long-term capital gains rates, you'd probably be looking at a tax bill of more than $5,000. But since it's in a Roth IRA, your tax is ... zero!
Another scenario to consider (but not count on) is if you manage to hit a real home run with an investment in your IRA. Let's say that you invested in drink-purveyor Hansen Natural (NASDAQ:HANS) a decade ago. If so, your $5,000 would have turned into about $1.1 million. Your gain, taxed at 15%, would amount to a whopping $165,000! But if the investment were in a Roth IRA, you'd save that $165,000. Similarly, a $5,000 investment in apparel retailer Chico's (NYSE:CHS) a decade ago would have turned into $865,000, and having it in your Roth IRA would save you a tax bill of perhaps $130,000.
There's a lot to learn and a lot to like about IRAs. Learn much more in our IRA Center, which features info on the various kinds of IRAs, eligibility restrictions, and even how to open an IRA. Plus, it offers a comparison chart for IRA accounts at Ameritrade (NASDAQ:AMTD), E*Trade (NYSE:ET), and Sharebuilder, so that you can see fees and other data at a glance.
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By the way, there's still time to contribute to your 2005 IRA -- you have until April 17, when your taxes are due. And this is as good a time as any to contribute to your 2006 IRA, while you're at it. That way, your money can start growing immediately.
Longtime Fool contributor Selena Maranjian owns shares of eBay, which is a Motley Fool Stock Advisor recommendation. The Motley Fool has a disclosure policy .
