If you're saving and investing for retirement, you probably know that employer-sponsored 401(k) plans can reduce your taxable income while you sock away greenbacks for tomorrow. 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 his or her spouse is employed.
  • Nearly half of respondents had less than $50,000 saved for retirement.

Jeepers! And those numbers came before last year's big drop in the stock market. If you see yourself in some of these numbers, please keep reading.

The ABCs of IRAs 
IRAs come in two different flavors: traditional and Roth. With the traditional version, 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 to just $45,000 in the eyes of the IRS. You'll only be taxed on that money when you start withdrawing it from the IRA in retirement, and by then, a lower income may put you in a friendlier tax bracket.

With a Roth IRA, you contribute post-tax dollars, so your current taxable income isn't reduced. But when you ultimately withdraw money from the account, after years of accumulation, you won't pay a dime in taxes.

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. Dividend payers like these could definitely benefit from an IRA's tax advantages:

Stock

Current Dividend Yield

ConocoPhillips (NYSE: COP)

4.0%

Procter & Gamble (NYSE: PG)

2.8%

Coca-Cola (NYSE: KO)

3.2%

Kraft Foods (NYSE: KFT)

4.0%

Vornado Realty (NYSE: VNO)

3.8%

Waste Management (NYSE: WM)

3.7%

Pfizer (NYSE: PFE)

4.1%

Source: Yahoo! Finance.

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

Contribution limits for 2009 and 2010 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, 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 will likely keep rising, making this a conservative estimate:

After:

Grows to more than:

Your total contributions:

5 years

$33,000

$25,000

10 years

$87,000

$50,000

15 years

$174,000

$75,000

20 years

$315,000

$100,000

25 years

$540,000

$125,000

30 years

$904,000

$150,000

Not too shabby. Although $5,000 may sound like a major commitment, especially during tough times, you can see how effectively that sum would grow for you over the long haul. And note that the longer the money stays invested, the larger it grows. Especially given IRAs' amazing tax advantages, the sooner you start investing, the more powerful your eventual returns.

Learn more about what IRAs can do for you from our IRA Center.

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. Coca-Cola, Pfizer, and Waste Management are Motley Fool Inside Value recommendations. Coca-Cola, Procter & Gamble, and Waste Management are Motley Fool Income Investor recommendations. The Fool owns shares of Procter & Gamble. Try our investing services free for 30 days. The Motley Fool is Fools writing for Fools.