In traditional investing, you have to worry about capital gains taxes eating away at your profits every time you make a trade, but the Internal Revenue Service treats IRAs completely differently. Funds you invest in an IRA are free of capital gains taxes entirely, although distributions are subject to regular income tax rates when you finally access your IRA.
How Capital Gains Work
In most cases, when you purchase an asset such as stock, real estate or a collectible and sell it for a profit, the Internal Revenue Service assesses capital gains taxes against the profit you realize from the sale, after expenses. The rate of this tax varies by the type of asset – for example, collectibles are taxed higher than investment properties – and how long you owned the asset before selling it: items owned for a year or more receive lower rates. When you buy and sell these types of assets within an IRA, however, capital gains do not apply.
IRAs and Tax Shelters
Any money you contribute into an IRA is fully sheltered from taxes while it remains characterized as an IRA asset. This sheltered status means that any stock trades you make in your IRA aren’t subject to gains taxes if you sell stocks and use the proceeds to purchase others with your IRA. Although this allows you to trade without the tax burden of traditional investments, on the flip side it prevents you from claiming losses as well.
Taxes and IRA Distributions
You don’t pay gains taxes on your investment revenue while it’s in the shelter of your IRA, but when you begin receiving distributions, the funds are fully taxable. You pay ordinary income tax – which is typically higher than capital gains rates – on all money you receive from an IRA, regardless of whether it’s investment income or funds you contributed from your wages on a pre-tax basis.
IRA Tax Shelters: The Down Side
While the idea of trading in a capital-gains-free zone can be attractive to investors, money you contribute to an IRA isn’t as easily accessed as funds in traditional investments. Although the IRS allows you to receive distributions at any time from your account, if you make an unqualified distribution, it assesses an additional 10 percent penalty in addition to income taxes against the distribution. Qualified distributions are those you make after you turn 59 1/2, distributions if you’re disabled and can’t work, or distributions of up to $10,000 to help pay for your first home.