What is an IRA? The answer might surprise you, because IRAs are more than mere retirement-savings tools. A piggy bank can be a retirement savings tool, but it's not too exciting and probably won't transform your retirement. But used well, an IRA can deliver a far better retirement than you currently expect.
What is an IRA?
Let's start with the basics. The two main kinds of IRAs are the traditional IRA and the Roth IRA, both of which limit you to $5,500 in contributions for 2014, plus $1,000 for those age 50 and up. (The limits remain the same for 2015.) With a traditional IRA, you contribute money on a pre-tax basis, so the value of your contributions is subtracted from your taxable income, thereby reducing the tax you pay now. (So if your taxable income is $50,000 and you contribute $5,000, your taxable income falls to $45,000, shielding $5,000 from tax in your contribution year.) The money grows and remains tax-deferred until you withdraw it in retirement, when it is taxed as ordinary income.
The Roth IRA, meanwhile, accepts only post-tax contributions, so you get no tax break up front. (Taxable income of $50,000 and a contribution of $5,000? Your taxable income is still $50,000.) But if you follow the rules, it is withdrawn in retirement completely tax-free.
The power of an IRA
To appreciate just how much an IRA can improve your retirement, let's run through an example. We'll be conservative, assuming you contribute $5,500 annually to a traditional IRA for 30 years, from age 35 to 65. If you invest well and the account's value grows by the stock market's long-term average annual growth rate of 10%, you'll end up with ... (drumroll ...) $995,000! That's right -- just about $1 million from a rather modest annual investment.
It's true that you might not earn 10% annually. (An average annual growth rate of 8% will still result in about $673,000, a rather significant sum.) But you'll probably increase your annual contribution as tax laws permit -- at least, you should. And if you are an excellent investor, or just a lucky one, you might exceed the 10% growth rate.
Remember that your big traditional IRA nest egg will be taxed upon withdrawal. If you got a 25% haircut on it, you'd still be left with $746,000 (or $505,000 if your growth rate was 8%.) Here's a powerful reminder: If you'd made those contributions into a Roth IRA, that $995,000 would be yours to keep without taxation. That's hard to beat.
Pros and cons of IRAs
IRAs have a few drawbacks that can offset their great benefits. Let's review some of them.
Along with the tax advantages (whether up front or deferred), IRAs are easy to set up at any reputable brokerage and many other financial companies. They also offer a wide range of investment options, such as stocks, bonds, mutual funds, and CDs, giving you choice and control. (With 401(k)s, you're typically limited to a bunch of mutual funds.)
On the minus side, your annual contribution limits are a bit on the small side, at least compared with 401(k)s, which have solid double-digit limits and often receive matching funds from the account holder's employer. The contribution limits also shrink to zero for high earners. Just like 401(k)s, traditional IRAs feature penalties if you withdraw money early.
Overall, though, the benefits of IRAs outweigh their disadvantages for most people. Social Security might be a great help in retirement, but IRAs, often along with 401(k)s, can make your golden years shine much more brightly.
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.