The two main ways an IRA can grow are through annual contributions and investment appreciation. However, there are limits to the annual contribution amounts allowed and not all investments are successful in the long term. Historically, IRAs have achieved an average annual return of 7 to 10%. Your profits increase when you invest your IRA contributions and investment earnings in opportunities to generate interest and dividends, such as stocks, mutual funds, bonds, exchange-traded funds and certificates of deposit.
IRAs grow through capitalization, which helps your money grow regardless of whether you contribute or not. All types of IRA work in the same basic way. The money contributed to the account can be invested in a variety of stocks, bonds, ETFs, mutual funds and other investment vehicles. These investments are tax-deferred, meaning that dividends and interest income received in an IRA are not included in the owner's income each year, and any capital gains are deferred from taxes.
In simple terms, as long as investments remain within an IRA, they will not generate any tax liability for the account owner. With that in mind, here's an overview of how different types of IRAs work, how IRAs work in terms of withdrawals, eligibility and investment making, and how to open an IRA. The bottom line is that by knowing how an IRA works, you can understand why they're a great way to save for retirement, and you can also make a smart decision when it comes to selecting the type of IRA that's best for you and which broker to use.