When your mutual funds make money, you receive the gains as distributions. If you keep your funds in an individual retirement account, you may owe less tax on the distributions than if you invested through a regular brokerage account. However, in exchange for this tax break, you need to keep your money in your IRA until retirement.
As long as you keep your mutual fund distributions in a traditional IRA, they are tax-free. Taxes are delayed on all of the investment gains that stay in the account. This may give the IRA a better after-tax investment return compared with a regular brokerage account. If your mutual funds paid a distribution in a brokerage account, you would owe taxes on the payout right away, even if you reinvested the gains. When the distribution is in a traditional IRA, it keeps growing and only gets taxed when you take it out.
When you withdraw your mutual fund distributions in retirement, your taxes depend on which IRA you used. If you invested in a traditional IRA, you will owe income tax on your investment gains and deductible contributions. Such contributions to an IRA are made with pretax money, so you owe taxes when you take this money out. You've also never paid tax on your mutual fund gains, so you owe taxes on those when you make a withdrawal. A traditional IRA only delays taxes on your money; it is not a tax-free account.
When you invest in a Roth IRA, you do not get an immediate tax deduction. This is because the account is funded with after-tax dollars and pushes your deduction to retirement. When you take money out of a Roth IRA in retirement, your entire withdrawal is tax-free. This means you never need to pay taxes on your investment gains, including your mutual fund distributions.
You are not allowed to make a retirement withdrawal until you are at least 59 1/2 years old. If you need to take your money out early, the Internal Revenue Service may charge you a 10 percent penalty in addition to regular income tax on your mutual fund distributions, including your investment gains and deductible contributions. When you make an early withdrawal from a Roth IRA, you only owe the penalty and taxes on your investment gains. You get your contributions back tax-free.
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.