You know you need to sock away lots of money for your retirement, as Social Security alone isn't likely to suffice and you probably don't have a pension. There's a good chance you're aware of, and using, a 401(k) plan at work. But don't forget about another powerful retirement-saving tool: the IRA account.
The IRA account comes in two primary flavors: the traditional IRA and the Roth IRA. Each offers tax-advantaged retirement saving, but in different ways. With a traditional IRA account, you contribute money on a pre-tax basis, subtracting your contribution from your taxable income so that your tax hit is smaller. The money is taxed later, at your ordinary income tax rate, when you ultimately withdraw funds in retirement. With a Roth IRA account, you contribute dollars on a post-tax basis, and when you withdraw money in retirement according to the rules, it's all tax-free.
The traditional IRA account is especially compelling for those who are in a high tax bracket now and expect to be in a low one in retirement, as the traditional IRA lets you delay the tax hit. The Roth is great for those who are many years away from retirement, as it permits a lot of growth that will eventually be enjoyed tax-free.
There are limits to these IRA accounts, of course. High earners may find that their ability to contribute to a Roth is reduced or eliminated, and their ability to make deductible contributions to a traditional IRA may be restricted as well. Still, most of us can contribute up to $5,500 in 2014, plus an additional $1,000 for those of us who are age 50 or older.
Those sums may not seem like much, but over long periods, they can grow significantly. Give an online calculator a whirl and you can see how much you might amass with regular contributions. As an example, assume you're 40 and planning to retire in 25 years at age 65, and you make annual $5,500 contributions that grow at about 8% per year. You can accumulate a Roth IRA account worth about $400,000 -- which will be all yours, tax-free.
Let's run the numbers for a traditional IRA account, too. If you save the same sum over the same period and also earn 8% on average, you'll amass around $434,000, which will be taxed on withdrawal. If it gets a 15% tax haircut, it will end up worth nearly $370,000.
What an IRA account can and can't do
While an IRA can be a powerful tool to help you sock away money for retirement, it probably can't meet your needs alone, as the IRA contribution limits are relatively low. That's especially true if you're near retirement and don't have many years in which to sock away money. Consider the examples above and imagine how much faster your nest egg would grow if you could chip in more each year. The contribution limits for 401(k) accounts, for example, are far higher, totaling $17,500 in 2014 (plus another $5,500 for those 50 and older). It's often best to contribute aggressively to both account types if possible.
On the other hand, an IRA account does have some distinct advantages, including a wider variety of investment options than most 401(k)s offer. Open an IRA at any fine brokerage, and you can invest in just about any stock or bond, and gobs of mutual funds, too. With a 401(k) account, you'll typically have a limited range of options, chosen by your employer or the plan management firm.
There's more to learn about IRAs and retirement planning. Take some time to get savvier, and you can end up living the retirement you've dreamed of.
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.