When it comes to planning and saving for your retirement, don't assume you're doing enough unless you've crunched the numbers to prove it. Participating in your workplace 401(k) plan is great, but are you investing enough to get all available matching funds? Do you know how much money you'll need to live on once you leave the workforce? For many folks, even socking away 10% of their income isn't enough, and they should aim for 15% or more. You can sock away a lot in your 401(k), but give serious consideration to an IRA account, too.
Let's start with what an IRA account is. Much like a 401(k), an IRA account is made for retirement savings, so it has certain advantages, as well as certain requirements. Money within an IRA grows tax-deferred and is exempt from capital-gains and dividend taxes so long as it remains in the account. You also get to choose whether you pay taxes on your contributions now or in retirement. In exchange for these benefits, you're expected to wait at least until age 59-1/2 before you begin to withdraw your funds -- otherwise, you can face substantial penalties.
The two main kinds of IRA accounts are the traditional IRA and the Roth IRA, both of which limit you to $5,500 in contributions for 2014, plus a $1,000 "catch-up" contribution for those 50 and up. The limits remain the same for 2015.
With a traditional IRA, you contribute money on a pre-tax basis. The value of your contributions is subtracted from your taxable income, so it reduces the tax you pay now. For example, if your taxable income is $60,000 and you contribute $5,000, your taxable income falls to $55,000, shielding $5,000 from tax in your contribution year. The money grows tax-deferred until you withdraw it in retirement, when it's taxed as ordinary income.
The Roth IRA, meanwhile, accepts only post-tax contributions, so you get no tax break up front. However, if you follow the rules, you can withdraw your savings in retirement completely tax-free. Furthermore, a Roth IRA, unlike a traditional IRA, allows you to withdraw your contributions (but not any gains) at any time without penalty.
Keep in mind that you don't necessarily have to choose between the two. So long as your total annual IRA contributions don't exceed the limit, you can fund both a traditional IRA and a Roth.
Why you need an IRA account
If you invest effectively, you can grow great sums of money in all kinds of accounts, but they aren't all tax-advantaged as IRAs are. With a traditional IRA, if you plow $5,000 into it annually for 25 years, you're shielding a total of $125,000 in income from taxation while it grows. And there's a good chance that when you withdraw funds in retirement, you'll be in a lower tax bracket than you are now, so you may take a smaller tax hit than you would have by investing in another vehicle.
With a Roth, getting to grow a big nest egg and having it all be available tax-free is pretty great, too.
Let's run through an example of how much money you can amass over time. We'll be conservative and assume that you contribute $5,000 to a traditional IRA for 20 years, from age 45 to 65. If you invest well and achieve the stock market's long-term average annual growth rate of 10%, you'll end up with $315,000. If you're lucky enough to be able to contribute for 30 years, your account will swell to $905,000.
You can end up with much more -- or much less -- than that example. If you averaged gains of 8% in that hypothetical situation, you'd end up with $612,000 after 30 years. But then, you may well be able to contribute more than $5,000 per year -- and if you can, you should, because even small increases in your contributions can make a huge difference in the long run. The maximum allowable contribution increases every few years or so to keep up with inflation, so keep track of the limits and adjust your contributions accordingly.
Keep in mind that if you're offered matching contributions to a 401(k) at work, then you should invest enough to receive the full match. Then focus on maximizing your IRA account.
Stocks for your IRA account
Another advantage of IRAs is the broad selection of investments they offer. A 401(k) generally offers a limited investment menu, while an IRA account set up at a brokerage will let you park your money in almost any stock or mutual funds. You will simply have more control. It's fine to stick with mutual funds -- especially broad-market index funds, which tend to be inexpensive and also tend to outperform most managed stock funds. But if you want to aim higher, you might consider adding a few stocks to your IRA mix.
A more conservative approach would be to add some blue-chip dividend-payers, such as Johnson & Johnson, The Walt Disney Company, Apple, Microsoft, Procter & Gamble, or AT&T. The best dividend-payers offer both stock-price appreciation and reliable dividend payments that grow over time.
If you can tolerate more risk and especially have many years to go before you retire, you might consider fast-growing stocks with the potential to skyrocket -- or to plummet. Examples would include Chipotle Mexican Grill, Tesla Motors, and The Priceline Group. You'll need to be able to tolerate volatility and be willing to keep up with the companies' progress, lest their performance or prospects deteriorate without your noticing. If you're an active trader who generates a lot of short-term gains, you can avoid big tax hits by doing that trading within a Roth IRA.
You can shape your IRA account in whatever way works best for you. Don't wait to invest and let the power of the IRA account improve your retirement.
Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter, owns shares of Apple, Chipotle Mexican Grill, Johnson & Johnson, Microsoft, Netflix, Priceline Group, and Procter & Gamble. The Motley Fool recommends Apple, Chipotle Mexican Grill, Johnson & Johnson, Netflix, Priceline Group, Procter & Gamble, and Walt Disney. The Motley Fool owns shares of Apple, Chipotle Mexican Grill, Johnson & Johnson, Microsoft, Netflix, Priceline Group, and Walt Disney. 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.