Stash money in an Individual Retirement Account (IRA), one of the most tax-efficient ways to save. IRAs allow investors to defer capital gains taxes until withdrawing funds from their account, providing investors with tax relief on stock profits they made while investing through this account.
Investors might be tempted to trade stocks and ETFs within their Roth IRA to take advantage of lower taxes; however, before investing it is crucially important that all associated costs of an IRA are taken into consideration.
No Capital Gains Taxes
One of the key attractions of a Roth IRA is that its investment earnings don’t incur capital gains taxes – due to using money that has already been taxed as income. When investments within it make a profit, that profit doesn’t face capital gains taxation — unlike with traditional brokerage accounts where all profit must be subjected to capital gains taxes.
Traditional IRAs give an upfront tax break when contributing money, but require you to pay taxes in retirement on any withdrawals made out of them. Roth IRAs do not impose these withdrawal taxes provided certain criteria have been fulfilled (such as being over 59 and meeting the five-year rule).
No Income Taxes
Individuals converting assets from traditional IRAs or qualified retirement plans into Roth accounts don’t face the usual 20% income tax withholding required of distributions from most other types of retirement accounts; instead they can request their financial institution withhold less than minimum amounts and use other assets as the source for paying any resulting tax liability.
Young investors, with years of compounding ahead of them to grow their account balances, may benefit from this type of flexibility. It can also prove useful for those who know they’ll likely enter higher tax brackets upon retirement and wish to take advantage of lower rates now.
Only after considering all aspects and effects, can an individual determine if, or how much of their pre-tax accounts to convert. There may be subtleties and add-on effects that must be considered; and these could make or break whether converting to Roth makes sense.
Roth contributions may be withdrawn at any time without incurring income taxes or a 10% penalty, and earnings (investment returns) without incurring taxes or penalties if you’re at least 59.5 years old and/or have held your account for at least five years.
However, if you are under 55, any withdrawal may be treated as non-qualified distribution and incur an early withdrawal penalty – making an IRA withdrawal an expensive last resort due to penalties and lost investment growth potential.
Some exceptions exist for early withdrawal penalties, including first-time home buyers. According to the IRS definition of first-time buyers as defined above (you and/or your spouse who haven’t owned a principal residence within two years) you may also take penalty-free distributions in order to pay costs associated with purchasing, building, or rebuilding a principal residence; or certain medical expenses not reimbursed by insurance policies.
No Required Minimum Distributions
Roth IRA investors who hold mutual funds, exchange-traded funds and certain bonds do not incur capital gains tax when selling these investments – this represents a considerable advantage that many retirement savers can take advantage of.
Traditional IRAs require you to begin taking minimum distributions (RMDs), starting at age 70 1/2. An RMD is calculated by dividing the value of your account by your life expectancy factor using IRS Publication 590-B tables.
If you leave an inherited Roth IRA in its entirety, there’s no requirement to take an RMD; its funds can continue growing without tax or penalty implications. But if transferred or used outside retirement purposes, those funds become taxable and subject to a 10% penalty tax rate.
Due to the tax implications, it would not be wise to convert from traditional IRA to Roth in early retirement or with other sources of income such as Social Security or self-employment that may be affected by higher tax rates.