Are Capital Gains in Roth IRAs to Be Taxed?
Individual retirement accounts allow you to set aside up to $6,000 of earned income in a tax-advantaged account, as of the 2019 tax year. The maximum increases to $7,000 if you are at least 50 years old. While traditional and Roth IRAs have some significant differences, they also a major similarity; all of the earnings on investments in the IRA, including interest, dividends and capital gains, are allowed to grow without being taxed, as long as they stay in the IRA.
Capital gains aren't taxed in a Roth IRA, but you'll have to take a qualified distribution to access them tax-free.
Capital Gains Definition
The Internal Revenue Service considers just about everything you own, including your home, your vehicle and your investments, to be capital assets. If you sell a capital asset for more than you paid for it, you have a taxable capital gain. The tax rate is different depending on whether the gain was short-term or long-term. Short-term gains are taxed at your ordinary income tax rate, while gains on assets you've owned for more than a year are taxed at the more advantageous long-term capital gains rate.
Roth IRA Assets
You can use funds in your Roth IRA to purchase almost any kind of investment other than life insurance or collectibles. The gains on assets you hold in your Roth IRA are not subject to current taxation. For example, you can buy 100 shares of stock in your Roth IRA and later sell it for a profit, and the capital gain from that transaction will not be taxed. Buying and selling within a Roth IRA amounts to a tax bonanza for account holders, as neither income nor capital gains are ever taxed.
Withdrawal of Contributions
You don't get to claim a tax deduction when you contribute to a Roth IRA. All Roth contributions must be made with after-tax dollars. Since you've already paid taxes on that money, you can withdraw an amount from your Roth IRA equal to your total contributions without creating a taxable event. You also won't pay any penalties for an early withdrawal, even if you take out contributions before you turn age 59 1/2. In other IRAs, this early withdrawal penalty is 10 percent.
Qualified Roth IRA Withdrawals
You can take tax-free withdrawals of the earnings portion of your Roth IRA once they become qualified. You must have had a Roth account for at least five years and meet one of the IRS's other qualifying events. The most common qualifying event is turning 59 1/2 years old, but your earnings can also become qualified if you become disabled or use the funds to buy a first home. Once the earnings are qualified, you don't owe any federal income taxes on those earnings, regardless of whether they were the result of interest, dividends or capital gains.
Non-Qualified Roth IRA Withdrawals
All the money in your Roth IRA, including any earnings from capital gains, belongs to you. You can withdraw those funds anytime you wish, for any purpose. The amount equal to your contributions will not be taxed, since you've already paid taxes on those funds.
However, your Roth is still intended as a long-term retirement account, and non-qualified Roth withdrawals should be avoided whenever possible. If you want to take out any earnings before you reach age 59 1/2, you're going to face taxes and penalties.
Specifically, any non-qualified earnings you withdraw from a Roth IRA will be taxed as ordinary income, regardless of whether they were the result of interest or long-term capital gains. This means that you'll be giving up the benefits of the long-term capital gains tax rate that you would pay if you took those gains in a regular, taxable investment account. The IRS will also hit you with a tax penalty equal to 10 percent of the amount of the non-qualified earnings.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.