If you're saving and investing for retirement, or you want to, you know that 401(k) plans are employer-sponsored retirement accounts that reduce your taxable income while permitting you to sock away greenbacks for tomorrow. Sure, they're terrific. But are you overlooking another terrific option?

According to a 2008 AARP survey of Americans about their finances, there's a good chance you're ignoring the noble IRA. Among the survey's findings:

  • 44% of Americans -- and half of those 18 to 49 -- say they don't understand how an IRA works.
  • 55% don't know the difference between a Roth IRA and a traditional IRA.
  • 67% don't know IRA contribution limits are higher for those 50 and older.
  • 71% believe that IRAs are "worth the bother," but only 39% have an IRA.
  • Half of those surveyed didn't know that a non-working person may be able to make an IRA contribution if their spouse is employed.
  • Nearly half of respondents had less than $50,000 saved for retirement.

Jeepers. And that's before 2008's big drop in the stock market. If you see yourself in some of these numbers, please keep reading. I have a few words for you.

The ABCs of IRAs 
Here's how they work. You choose between a traditional IRA and a Roth IRA. With the traditional, you contribute money on a pre-tax basis into a special account, where it can grow, tax-deferred, until you withdraw it in or near retirement.

In short: If you earn $50,000 per year and you contribute $5,000 into a traditional IRA, your income is reduced by that much, and so you end up paying fewer tax dollars. Eventually, when you withdraw money from the IRA, you'll be taxed on the withdrawals then, perhaps at a lower rate due to having less income.

With a Roth IRA, you contribute post-tax dollars -- that is, your current taxable income isn't reduced. But when you ultimately withdraw money from the account, you will be able to do so tax-free.

You can put money in stocks, bonds, and other investments with an IRA. Because taxes are deferred or bypassed, it can be smart to hold investments that pay substantial income within an IRA. Those may include:

  • Real estate investment trusts (REITs), such as Simon Property Group (NYSE:SPG) and Vornado Realty (NYSE:VNO).
  • Energy royalty trusts like BP Prudhoe Bay (NYSE:BPT) and San Juan Basin Royalty Trust (NYSE:SJT).
  • High-yielding stocks like DuPont (NYSE:DD), GlaxoSmithKline (NYSE:GSK), and Southern Company (NYSE:SO).

Putting income-producing investments inside an IRA takes maximum advantage of the tax deferral IRAs offer.

Contribution limits for 2008 and 2009 (and by the way, you still have until April 15 to make your 2008 IRA contribution) are $5,000 for most of us and $6,000 if you're 50 or older.

The power of an IRA
If you need a visual aid to really understand how powerful an IRA can be, try this. The chart below shows how your money would grow in an IRA (at the market's historic average annual growth rate of 10%) if you contributed $5,000 per year. Note that contribution limits are likely to keep rising, so this is a conservative estimate:


Grows to more than:

Your total contributions:

5 years



10 years



15 years



20 years



25 years



30 years



Not too shabby, eh? To many people, $5,000 per year isn't a major hardship, and you can see how effectively it would grow for you over time. And note that the longer the money stays invested, the larger it grows -- that's why it's critical to start saving and investing as soon as possible. Your earliest years are your most powerful ones.

Take action, get help
So what should you do now? Well, open an IRA account, if you haven't done so already!

For more on how IRAs can help you:

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Frustrated with your 401(k)? Even if your employer's plan isn't the greatest, you don't have to give up your dreams of a happy retirement. Get the tips you need to turn your retirement savings around in our special report, "How To Make The Most of Your 401(k)" -- just click here for instant free access.

This article was originally published on March 19, 2008. It has been updated by Dan Caplinger, who doesn't own shares of any companies mentioned in this article. GlaxoSmithKline and Southern Company are Motley Fool Income Investor selections. Try our investing services free for 30 days. The Motley Fool is Fools writing for Fools.