That Makes Cents: What's an IRA?

At some point you may begin to worry about how you're going to live in retirement. That's the time to start thinking about ways of putting money away and how to do it with the maximum tax advantage. That's where an IRA comes in.

An IRA, or Individual Retirement Arrangement, is a good way to generate tax-deferred savings for that day when employment ends and retirement begins. It's easy to set up and these days you can usually manage your IRA account from your cell phone – deposits and all.

You decide how much of your current earnings you can afford to set aside for retirement. Most financial planners recommend setting aside a minimum of 10 percent of your income. So if you're making $3,000 a month and you're paid twice monthly, you'd set aside $150 out of each paycheck. If you can afford more, all the better.

Next, you'll need to open an IRA brokerage account. Most people use one of the big online brokers, like Schwab or Ameritrade, but any well-established online discount broker will work. Setting up the account online is super easy and will probably take you less than 10 minutes.

If you do a quick online search for "Schwab," for instance, you can click on the "Open New Account" box on the upper righthand side of the home page. Then click on "Retirement Account," and choose one of three IRA types: Traditional, Roll-over or Roth – there's more info about these three types below.

Once you've selected one of these IRAs, the form will walk you through the rest of the process. You'll provide name, address and Social Security number for yourself and the beneficiary you designate.

And that's it! You'll activate your IRA with your initial deposit. Note that this first deposit usually has a $1,000 minimum. After that, you can deposit whatever amount you choose.

With a Traditional IRA, money you put into your IRA isn't taxed until you withdraw it in retirement. This may not sound like a big deal, but it is. Here's a comparison of what you'll end up with when your deposits are tax-free vs. when they're not (the difference may surprise you).

You begin with an initial $1,000 contribution when you're 25, then contribute $300 each month until you're 65 – 10 percent of your monthly income, as in the example above. If the money in your IRA returns nine percent annually – the average stock market return – when you're 65 you'll have $1,465,064 in your IRA account.

If, on the other hand, you put in only what's left of that $300 after federal taxes on a $36,000 annual income, when you're 65 you'll have $1,269,315 in your IRA account – a $195,749 difference. More than enough money to fund a year-long worldwide luxury cruise.

Or, maybe not! Remember that with a Traditional IRA, you're signing up to pay whatever the tax rate may be when you withdraw the money many years later. For the past few decades, U.S. tax rates have been trending downward, but there's no guarantee that will continue. A Roth IRA avoids that uncertainty.

A Roth IRA also offers substantial relief from taxation that helps your money grow, but it does it in a way that's almost the opposite of a Traditional IRA.

As stated above, with a Traditional IRA you put your money in the account before it's taxed, then let it grow tax-free until you've retired. You begin paying taxes on the money as you withdraw it.

With a Roth IRA, you pay taxes on the money at the time it's earned, just as you do with ordinary income. But once you put the money into a Roth, it's never taxed again.

Using the same $36,000 annual income as an example, here's how this works with a Roth. You plan to contribute $300 before taxes. However, since you are paying taxes on your Roth contributions, that's equivalent to a monthly post-tax contribution of $258.87 (at time of publication). Multiply that by 12 and you get your annual contribution, which is $3,106.44.

If you start these $3106.44 annual contributions at age 25 and retire at 65, you'll have 40 years of compounded growth. If your investments return the nine percent historical stock market average, upon retirement you'll have $1,465,064.

But notice this: Over 40 years you've contributed a total of $124,257.60, yet thanks to compounded returns you have $1,465,064 in your account. The difference between what you've contributed and what's in the account is $1,340,806.40 and it's tax-free.

In most cases, you'll choose either a Traditional IRA or a Roth IRA (or a combination of the two) for your retirement savings. However, if you're leaving employment with a company that offers a 401k plan – another retirement savings plan broadly similar to an IRA, but managed by an administrator – in most cases you'll want to convert that 401K to an IRA. For one thing, the 401k administrator takes a bite out of every dollar of yours he manages. With an IRA, you're the administrator.

Doing the rollover isn't complicated, but there are two ways of doing it; with one of them, timing is an issue. The first way is to ask the administrator of the 401k plan you're leaving to transfer your funds to your IRA, usually by sending a check directly into the new account. The other way is to pick up the check from the administrator, then deposit it in your IRA yourself. This is where you have to be diligent: If you pick up the check from the administrator, you've withdrawn the funds from a retirement fund. You have 60 days to get it back into another retirement fund or the IRS will consider the funds distributed – in other words, taxable and potentially penalized. For this reason, it's usually a better idea let your administrator make the transfer.

You may occasionally read a blog or financial opinion piece that suggests that one of these plans is better than the other. And in many instances, depending on individual circumstances, one will be better, but there's no overall winner. It depends on your financial circumstances.

If you really want to get into the weeds on this decision, you can always read IRS Publications 590-A (60 pages of info on contributions to the two plans) and 590-B (59 pages discussing disbursements from the two plans). They're a bit of a slog, but after a few hours you'll know more about both plans than almost anyone you've ever met.

For most persons, the decision needn't take quite so much information into account. These are the two most important points to keep in mind:

• A Roth, not a Traditional IRA, has income limits, but they're fairly high. You can only contribute to a Roth if your income as a single person is less than $131,000 or if your total income as a married couple is less than $193,000.
• Most analysts consider a Traditional IRA a better choice when you're in a higher tax bracket and a Roth a better choice when you're in one of the two lower brackets.