In almost all cases, you can change funds (or stocks or any other equity) in a Roth IRA without tax consequences. Only available since 1998, Roth IRAs provide an interesting and popular alternative to traditional IRAs (Individual Retirement Arrangements). By 2014 they'd accumulated over $500 billion in assets, providing investors a unique opportunity not only to defer taxes on retirement accounts, but after an initial taxable event, to avoid them altogether. Here's how this works.
Generally speaking, you can change the specific funds in your Roth IRA account without incurring tax penalties.
Roth IRAs and Taxes
When you invest in a traditional IRA, (or a 401(k) or any retirement investment other than a Roth IRA), you invest the money before you've paid taxes on it. The money can grow for decades without being taxed. In retirement, however, as you draw money from the IRA for retirement expenses, you have to pay income tax on the amount withdrawn.
With a Roth IRA, you pay taxes on the money at the time you invest it. But, here's the unique advantage: the money can grow in the account for decades and when you withdraw it in retirement, withdrawals are tax-free. When you think about this, you'll see that Roth IRAs provide investors an incredible advantage, and particularly for the newer and younger investors who typically open these accounts.
Example of the Benefits of a Roth IRA
For instance, if you begin investing in your Roth IRA at age 30, and make the maximum allowable investment for investors 50 and under of $5,500 each year, then step up your annual contributions to the annual maximum of $6,500 until your retirement at age 70, you'll have contributed a total of $240,000.
If you've invested the money in a Standard & Poor's 500 index fund with an average long-term gain of 10 percent, when you've reached 50 you'll have accumulated more than $360,000. By the time you retire at 70, with your stepped-up contribution of $6,500 that's allowed at age 50, you'll have over $2.8 million in your Roth! (Please note that these returns are an approximation that do not account for daily compounding. While an approximation, the differences are not considerable).
But here's the best part: you've contributed a total of $240,000, less than 10 percent of what you've got in the account. You've paid income taxes on the contributed amount each year. But the entire amount of more than $2.8 million is yours to withdraw in retirement entirely free of taxes.
Switching Investments in a Roth IRA
In an individual investment account – one that's not entitled to the advantages of a retirement account – whenever you sell an equity at a profit, even if you immediately buy another equity to replace it, you've still created a taxable event. Depending upon how long you've held the equity, you'll either pay taxes on the gain at the so-called "short-term capital gains rate," which is really just the ordinary income tax rate, or at best, you'll pay at the long-term capital gains rate, which for a majority of investors will be 15 percent.
In a Roth IRA, however, you're free to switch equities – selling current equities at a profit and then reinvesting in a different equity – as often as you like, tax-free. Period. There are no other qualifications. You can reinvest or not. Not that it's a great idea, but there are no tax consequences even if you keep the money in cash, so long as you leave it in the Roth IRA.
A Potential Warning
The above information is based on the assumption that you're buying and selling either mutual funds, ETFs or individual stocks of public corporations called C corporations, which is what almost all investors normally do. Few investors, however, also invest in S corporations, LLCs (limited liability companies) or Master Limited Partnerships.
For complicated tax reasons that go beyond the limits of this article, holding such investments in a Roth IRA doesn't provide the same tax advantages and tax advisers generally advise against holding them in a retirement account. Since the issue can be complicated, it's a good idea to get advice from a tax specialist about what's best for you.
I am a retired Registered Investment Advisor with 12 years experience as head of an investment management firm. I also have a Ph.D. in English and have written more than 4,000 articles for regional and national publications.