A traditional individual retirement account might be just the right place for you to stash some of your hard-earned dollars. Depending on your income, you can contribute up to $6,000 each year into your traditional IRA. The max goes up to $7,000 once you hit 50. You get to take a tax deduction for your contributions, and all of your investments grow tax-deferred as long as they remain in your IRA. This includes capital gains.
The IRS considers all of your income, including any capital gains you earn when you sell an asset, to be taxable income, unless federal law exempts that income from taxes. If you sell some stock for more than you paid for it, Uncle Sam wants his cut. One of the big benefits of a traditional IRA is tax-deferred growth of your investments. It doesn't matter what kind of growth the investments in your IRA produce; interest income, dividends and capital gains are all treated the same. As long as the money stays in your traditional IRA, you don't pay taxes on any of the growth.
Things change in your IRA once you turn 59 1/2 years old. That's when you can start taking distributions from your IRA without incurring an early distribution penalty. The IRS taxes any money you take from your traditional IRA as ordinary income, regardless of how you earned the money. Earnings from dividends, interest and capital gains are all treated the same way.
All of the money in your traditional IRA, including your contributions and any growth that occurred within your IRA, belongs to you. You can withdraw it any time you want. If you withdraw money from your traditional IRA before you turn age 59 1/2, you'll owe ordinary income taxes on that amount and a 10 percent tax penalty. The IRS will waive the early distribution penalty in certain cases, such as if you become disabled or use up to $10,000 to pay for a first home. Even if you avoid the penalty, you'll still owe ordinary income taxes.
A traditional IRA can greatly reduce your tax liability. Most people find themselves in a lower tax bracket when they retire and begin living on a fixed income. For them, paying tax on their money after they stop working results in a much lower tax rate. It is, however, possible to find yourself in a higher tax bracket for some reason. If you happen to be in a higher tax bracket when you start taking distributions than when you made your contributions, you might still come out ahead because of the tax-deferred growth of your investments. You might not come out ahead, however, on any capital gains in your traditional IRA.
Long-term capital gains in an ordinary account are typically taxed at the more advantageous long-term capital gains rate. Since all withdrawals from your traditional IRA get taxed as ordinary income, you might pay a higher tax rate on those gains.
- Fairmark: Basic Questions About Capital Gains and Losses
- CNN Money: Ultimate Guide to Retirement
- IRS: Publication 590-B (2017), Distributions from Individual Retirement Arrangements (IRAs)
- IRS: Publication 590-A (2017), Contributions to Individual Retirement Arrangements (IRAs)
- IRS: Retirement Topics - IRA Contribution Limits
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.