Gains are profits made from an investment. There are two types of gains — unrealized and realized. A realized gain is created when an investment is sold for a profit. Most realized gains are taxable. Depending on whether the gain is short-term or long-term, the tax rate will differ. How does that compare when those gains are created in a retirement account such as an IRA? That’s what we’ll look into now.
Tax Shelters
An IRA is a type of tax shelter. The sale of an investment for profit is not taxed in an IRA, at least not at that time. This includes dividend payouts. The sale of an asset and dividend payout are both considered realized gains.
What does “at least at that time” mean? Realized gains in a traditional IRA are tax-deferred. Realized gains in a Roth IRA are never taxed as long as certain conditions are met. Let’s discuss these two types of IRAs.
Traditional vs. Roth IRA
Contributions to a traditional IRA are pre-tax or tax-deductible. This is similar to 401k contributions, where funds go in without being taxed. However, once withdrawals are made from a traditional IRA, they are taxed at the individual’s short-term tax rate. This is where the term tax-deferred comes in.
Gains or growth are not taxed in an after-tax IRA (i.e., Roth IRA), even when withdrawn. It’s only the principal contribution that is taxed.
Roth IRA contributions are after-tax dollars. In other words, money that goes into a Roth IRA has already been taxed. However, withdrawals are not taxed as long as certain conditions are met.
Note that the minimum age to withdraw from either IRA is 59 ½. Withdrawing before that age can result in a 10% penalty and taxes owed on the amount withdrawn, although there are some exceptions.
Traditional IRAs require minimum distributions or RMDs. The RMD age is 72. This means an investor will have to withdraw from a traditional IRA at 72.
When deciding between a traditional or Roth IRA, one of the primary factors is whether the investor’s earnings will be higher now or later? If the investor believes that he’ll earn more in later years, a Roth IRA might be best since the investor won’t have to pay higher taxes on the withdrawals.
Are Realized Gains in an IRA Taxable?
As mentioned above, taxable events aren’t created in an IRA account unless there is a special situation. Selling shares of stock for a profit (i.e., a realized gain) in an IRA doesn’t generate a taxable event. However, any time funds are withdrawn from a pre-tax IRA, they are taxed.
But realized gains do create growth. Neither of the two IRAs will tax that growth at the time the realized gain was created, but growth will be taxed in a pre-tax IRA at the time of withdrawal.
IRA owners should be aware of UBIT, which stands for unrelated business income tax. UBIT is a taxable event within an IRA. It occurs when an IRA invests in a trade or business outside the IRA’s tax-exempt purpose. Using debt to generate income can also trigger a UBIT.
