When it comes to planning for retirement—Americans are behind the curve. A recent survey conducted by an independent research firm for the TIAA-CREF found that over half of those surveyed do not understand what an IRA is. It should be no surprise then that around 80% report that they indeed do not make regular contributions to an IRA.

What is an IRA?

IRA stands for “Individual Retirement Account ”. While the IRA comes in a number of shapes and sizes, the common theme for all IRAs is that it allows individuals to put away savings for retirement in a tax deductible or tax free manner.

What are the different types of IRAs?

The two main types of IRAs that you here about normally are the traditional IRA and the Roth IRA. On first glance, these two types of investment savings may seem identical, but they actually have several key distinctions.

• Eligibility:  While traditional IRAs are open to everyone, regardless of income level, Roth IRAs are only available to single individuals making up to $95,000 or married couples making up to $150,000.

• Taxation:  Contributions made to traditional IRA accounts are tax deductible, unlike the Roth IRA. For the Roth IRA, if you make $30,000 a year and make a $2,000 contribution, you owe taxes on the full $30,000 and not $28,000 like you would in a traditional account. On the other hand, when you retire and make withdrawals from your IRA, the withdrawals from a Roth IRA won’t be taxed, unlike the traditional IRA. So the decision of whether to choose a Roth or Traditional comes down to your view on taxes. For many people, income will increase over their career and they will be in a higher tax rate when they retire than they are during most of their career so a Roth makes more sense. You should also take into account whether you think overall tax rates will rise or fall. Even if you think you may earn less in the future and would therefore be in a lower tax bracket, tax rates in your state or the federal rate may go up (or down).

• Withdrawal:  You can make withdrawals of your contributions at any time from a Roth IRA. These withdrawals are subject to particular minimum conditions. On the other hand, for the traditional IRA, if you make any withdrawals before the age of 59 ½, you must pay a 10% penalty fee and income taxes on your withdrawal.

Other less well known IRAs includes:

• Spousal IRA: an IRA for non-income earning spouses.
• Rollover IRA: an IRA that allows flexible rollovers in savings as you switch jobs.
• SEP-IRA: an IRA plan for the self-employed.
• SIMPLE-IRA: an IRA catered to small business owners.
• Education IRA: used to pay for college.

What are the advantages of an IRA?

The primary advantage of the IRA is tax-advantaged compound interest. No matter the type of IRA account you choose, if you make regular contributions from an early age, you will be left with quite a nest egg by the time you reach retirement age.

For example, if at the age of 23 you started to contribute the maximum of $5,500 a year to an IRA, by the time you hit 63, assuming stable returns, you could be sitting on over $1.5 million. If you had a Roth IRA, you could start making withdrawals from that $1.5 million account tax-free.  This is because you are taxed upfront on contributions, rather than upon withdrawal.

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