What is an IRA?

From FinancialPlanning

An IRA is a type of account intended for retirement savings, which provides tax advantages when used for that purpose. The tax code sets limits on the amount you can contribute to an IRA each year, rules for when you can take money out of it without paying penalties, and rules for when you must take money out of your IRA. The rules and associated tax benefits vary by type of IRA. These rules are addressed in the FAQ section on types of IRAs.

The principal tax advantage of all IRAs is that earnings in the account grow tax-deferred, meaning you do not pay taxes on income each year. For example, if the investments in your IRA earn $600 in interest during a given year, you will not be taxed on that interest on that year's tax return, and all of the money can remain invested. Similarly, if you sell a stock or mutual fund at a gain within the IRA, those gains won't be taxed either.

How much of a difference does tax deferral make? Let's say you pay a total of 25% in federal and state taxes on your income. An investment earning 6% in an IRA would net only 4.5% annually if held in a taxable account (because 25% of the income would be paid out to taxes). Over time this leads to very big differences in the growth of the account. After 10 years, $10,000 would grow to about $18,000 in the IRA, but only $15,500 in the taxable account. After 20 years, it's $32,000 vs. $24,000 and after 30 years, it's $57,400 vs. $37,500. There's 53% more money in the IRA.

Traditional IRAs also provide a tax deduction when you add money to them, so you're able to contribute "before-tax dollars." This gives you an immediate tax benefit because it lessens the out-of-pocket cost of the contribution. If you contribute $4,000 to a traditional IRA and the contribution is deductible on your tax return, you reduce your taxable income by $4,000. If you would have paid 25% to taxes, you'll save $1,000 on your tax return. In effect, you made a $3,000 contribution out of pocket, and the other $1,000 was money that would have otherwise been paid to the IRS.

Sidebar: Do IRAs really provide tax benefits?
A minority view occasionally expressed on MIFP, that certainly applies to some people, is that accumulating assets in an IRA may simply set you up for a bigger tax bite in the future. If your tax rates rise significantly, and your IRA is a type that triggers taxes when you take money out of it, you could just end up paying all those extra gains out to higher taxes.

It's hard to judge the validity of this opinion, given that nobody knows what future tax rates will be. One approach mentioned occasionally on MIFP is hedging your bets a bit, saving money in both tax-deferred IRAs as well as in accounts that don't spool up big future tax liabilities. That way, if future tax rates are high, you won't be hit with those taxes on all of your investments; if they're low, then you'll benefit from the tax-deferred assets you did save up. Most people split their savings between tax-deferred retirement accounts and taxable accounts for other reasons.