If you've been hearing rumors about your neighbor or co-worker's IRA account, then let me set the record straight: They're probably true. In short, there are few things as advantageous to the average American as an individual retirement account sanctioned by the IRS.

Why you should have an IRA today
In short, virtually every working American would benefit from having an IRA. And the best news is that they're easy to understand and can increase your tax refund by more than $1,000 a year. For fear of getting ahead of ourselves, however, let's start with the basics.

IRA stands for "individual retirement account." In many ways these are indistinguishable from a standard savings account. Most banks and discount brokerages offer them. Their purpose is to store your money until future use. And, within predefined limits, they can be added to at your leisure.

The biggest difference is that once money is deposited into the account it can't be withdrawn absent a stiff penalty until you turn 59.5 years old. In this respect, an IRA serves as a way to gently cajole Americans into preparing for retirement.

Now, just to be clear, there are two general types of IRAs. The first is a Roth IRA, which allows your contributions to grow tax-free even once you withdraw them -- this, of course, is assuming you invest the funds. And the second is a traditional IRA, which is what we're interested in here.

A traditional IRA is particularly attractive because it allows you to deduct the contributions from your income taxes in the current year up to a maximum of $5,500 -- an important caveat is that the deduction is gradually phased out for single individuals who earn more than $112,000 and married people filing jointly with a combined income of $178,000.

An example of how an IRA can save you money
By way of example, let's assume Stephen earns $60,000 in taxable income working as a machine engineer in a local equipment factory. If he's single and doesn't qualify for any other credits or deductions, Stephen would end up owing the federal government $10,856 in income taxes.

By contrast, now let's assume Stephen contributes $5,500 to a traditional IRA, which is equal to the 2014 limit. By doing so, he reduces his taxable income to $54,500 and thereby drives his income tax liability down to $9,481.

Income Tax Line Item

Without IRA Contribution

With Traditional IRA Contribution of $5,500

Gross Income



Taxable Income



Tax Bill






Excluding the impact of unrelated credits and deductions. Source: author.

The immediate benefit to Stephen, in other words, is a $1,375 cut to his tax bill; another way to look at this is that it adds a comparable amount to your refund if taxes are automatically withheld from your paycheck.

Taking this one step further, moreover, if you compare the $1,375 figure to the amount set aside -- i.e., $5,500 -- then Stephen effectively achieved a single-year return on investment of 25%, or nearly triple the long-run average of the S&P 500 (SNPINDEX:^GSPC).

The point here is that an IRA account -- and, specifically, a traditional IRA -- is effectively free money. Or, at least, it's the closest thing to free money that most of us are likely to ever come across.

John Maxfield and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.