The Tax Consequences of Mutual Funds Not in an IRA

For those seeking an effective investment vehicle that they can use to further their retirement goals, mutual funds are an excellent choice. A mutual fund can be defined as a collection of funds that have been sourced from a large number of investors as part of an investment strategy that may involve securities such as stocks, money market accounts, bonds and other popular tools. Given their high degree of popularity, mutual funds are often integrated into IRAs in order to help promote sustainable growth over an extended period of time.

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Taxation on mutual funds outside of IRAs differs greatly from the rules governing IRA distributions. Profits from non-IRA mutual funds are taxed at capital gains rates, while IRA withdrawals may be taxed as ordinary income.

Understanding Mutual Funds Outside of IRAs

Although mutual funds are commonly linked to IRAs, this doesn't mean to imply that mutual funds can only be invested in as part of these retirement savings plans. In fact, mutual funds can be integrated into the investment strategy of individuals of all ages and financial backgrounds. That being said, if an individual chooses to invest in a mutual fund outside of an IRA, they will be required to pay taxes in a different manner than those whose mutual fund holdings are wrapped into their retirement accounts. With these ideas in mind, it is essential that individuals take the time to properly explore and assess tax laws for retirement mutual funds that are not affiliated with an IRA. Fortunately, an array of information related to these policies is widely available online and through official governmental agencies, including the Internal Revenue Service.

Exploring Taxes on IRA Accounts

As a general rule, the tax laws pertaining to IRA investments have little bearing when it comes to investing in a mutual fund outside of an IRA. Perhaps the most critical distinction between IRA taxes and the taxes incurred through mutual fund investments outside of an IRA involves capital gains rules. In order to properly understand this, it is best to first consider an overview of IRA tax regulations.

Each of the two primary IRA formats – traditional and Roth IRAs – carry their own unique tax stipulations. For example, whereas a traditional IRA is funded with tax-deferred income, individuals must pay tax on funds placed inside of a Roth IRA prior to completing the deposit. When funds are eventually withdrawn from these IRAs, the inverse taxation rules apply. Traditional IRA withdrawals will be taxed according to ordinary income rates, while withdrawals taken from a Roth IRA will not require tax payments due to the fact that taxes on these funds have already been paid once.

It is important to note here that the amount of growth within the IRA will not be used as a measure of taxation. For example, if the size of a Roth IRA grew from $50,000 to $500,000 over the lifetime of the account, the $450,000 "profit" earned here is irrelevant with regards to tax law. When an individual makes withdrawals from a traditional IRA, the total sum of earnings taken out of the account is taxed regardless of how much they have fluctuated over the duration of the investment.

Assessing Capital Gains and Mutual Funds

This method of taxation outlined in the previous paragraph is at odds to the methods used to tax mutual funds outside of an IRA. Profits derived from mutual fund investments that are not part of an IRA are taxed at capital gains rates. With the capital gains system, the amount of profit derived from the investment (i.e. the final value of the fund minus its initial value) will be used as the basis of taxation.

For individuals who have held onto their mutual fund investments for more than a year, significantly lower tax rates will be available compared to those attached to mutual fund profits created in less than 12 months. Herein lies the distinction between long-term and short-term capital gains. Long-term capital gains can be defined as any profit derived from an investment that was held for more than 12 months, while short-term capital gains include any profits from investments that have been bought and sold in less than 12 months.

Whereas capital gains factor prominently into a discussion of mutual funds and the taxes attached to them, the taxes associated with IRAs are simply standard income taxes and do not share any similarities to those associated with mutual funds.

Exploring Tax and Time Issues

Although it may initially seem that individuals holding mutual funds in an IRA are receiving a far better "deal" than those investing in these funds outside of a retirement account, it is important to factor in additional regulatory parameters before comparing their relative worth. One of the most important distinctions between IRA investments and investments made in mutual funds is the degree of flexibility with regards to accessing this money. Once funds have been placed inside of an IRA, any attempt to withdraw them before age 59 1/2 could result in substantive early withdrawal penalties. The standard early withdrawal penalty associated with IRAs is 10 percent of the distributed amount. With a standard mutual fund, however, the balance of the account can be withdrawn at any time without sustaining similar fiscal penalties.

It is also important to note that IRAs carry with them a maximum annual contribution limit, while standard mutual funds do not. For tax year 2019, individuals under the age of 50 can contribute a maximum of $6,000 to their IRA on an annual basis. When a single tax filer's income level exceeds $137,000 during tax year 2019, they will no longer be eligible for Roth IRA contributions. Such regulations do not exist in the world of standard mutual fund investing. Regardless of your current income status, you are capable of investment whatever sum of money you desire in keeping with your general investment strategy.

Moving Forward With Your Investment

It is also important to note that investments in mutual funds inside and outside of an IRA do not have to be mutually exclusive. In fact, diversifying your retirement investments across a variety of platforms is strongly recommended in order to ensure the best prospects for stability and success. If you have any questions about tax laws relating to your mutual fund or IRA, it is in your best interest to discuss them with a financial advisor or tax professional as needed. Given the harsh fines associated with faulty tax filing, you should always ensure that you have the information you need to complete your tax obligations correctly.

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About the Author

Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.


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