If you're thinking of IRAs merely as ways to save some money for retirement, you may be shortchanging your financial future. Used effectively, the IRA can be a powerful income generator for your retirement.
Continue Reading Below
Traditional and Roth IRAs deliver tax savings
Let's first review just what IRAs are and how they work. There are two main kinds of IRAs -- the traditional IRA and the Roth IRA.
Don't leave your retirement to chance. Image source: Getty Images.
With a traditional IRA, you contribute pre-tax money, reducing your taxable income for the year and thereby reducing your taxes, too. (Taxable income of $70,000 and a $5,000 contribution? You'll only report $65,000 in taxable income for the year.) The money grows in your account and is taxed at your ordinary income tax rate when you withdraw it in retirement. Many of us will be in lower tax brackets in retirement, so not only is our taxation postponed, but it's often reduced.
With a Roth IRA, you contribute post-tax money that doesn't reduce your taxable income at all in the contribution year. (Taxable income of $70,000 and a $5,000 contribution? Your taxable income remains $70,000 for the year.)Here's why the Roth IRA is a big deal, though: If you follow the rules, your money grows in the account until you withdraw it in retirement --tax free.
For the 2016 and 2017 tax years, the total contribution limit for IRAs is $5,500 -- plus an additional $1,000 if you're 50 or older.
Image source: Getty Images.
IRAs build future financial security
Most people would be we well served by maxing out their IRA account(s). Contribute as much as you can each year. A few thousand dollars may not sound like much, but it adds up each year, and it grows, too. The table below shows how much you can amass over time by generously funding an IRA and perhaps other retirement accounts, as well. (A 401(k), for example, will add to your tax-advantaged savings potential.)
Calculations by author.
Of course, you'll want to invest the money effectively, too. A 401(k) account will typically restrict you to a limited menu of investment choices, but through IRAs, you can be invested in just about any stocks and mutual funds, among other things. (Our IRA Center offers some options.) Over decades, stocks are one of the best ways to grow your nest egg, outperforming most alternatives, such as bonds, gold, and real estate.
Image source: Getty Images.
IRAs can deliver future income
Those are rather hefty totals in the table above. Even if you're just able to sock away $10,000 annually for 20 years, you can end up with close to $500,000. That can clearly support you for a number of years, but if you're wondering just how many, dust off the old "4% Rule." It's not perfect, but it can give you a rough idea of how to draw down your nest egg.
In order to have your money last about 30 years, it suggests withdrawing 4% of your balance in your first year of retirement, and then adjusting each subsequent annual withdrawal for inflation. So a balance of $500,000 will generate an initial annual income of $20,000. Add that to the average annual Social Security benefit of about $16,000 and you've got something to work with.
Ideally, you will have socked away more than $500,000, and ideally, you'll have collected above-average earnings in your working life, leading to higher Social Security benefits. If you can collect $25,000 from Social Security and $40,000 from a million-dollar nest egg, you're looking at $65,000 in retirement income -- a rather serviceable sum for many people.
Don't neglect the power of an IRA account when you plan for your retirement. Not every employer offers a 401(k) account, but most of us are able to enjoy the tax savings of an IRA.
The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after.Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.