Confused Regarding Do & Dont's Roth & Traditional IRA's

Once you've put money into a Roth IRA, you can trade mutual funds or other securities within your account without any tax consequences. That's also true for traditional IRAs. The two types of IRAs differ, however, in what happens when you sell a mutual fund and withdraw the money.

Key Takeaways

  • You can trade mutual funds within your Roth IRA (or traditional IRA) without tax consequences.
  • If you plan to sell a mutual fund in a Roth IRA and withdraw the money, you won't owe any tax as long as you meet the criteria for a qualified distribution.
  • With traditional IRAs, you'll owe tax on your profits as well as your previously untaxed contributions.

By contrast, with mutual funds held outside of IRAs and other tax-advantaged accounts, you will owe taxes on your profits each time you sell a fund—even if you're just moving the money from one fund to another in the same mutual fund company.

Roth IRAs and traditional IRAs operate differently with regard to taxes in other important respects, as well. With Roth IRAs, the money you put in is taxed as part of your income, and at your current marginal tax rate, for the year that you make the contribution. In a traditional IRA, however, your contributions are made with pretax income. That is, the money isn't taxed at that point, but it will be taxable when you eventually take distributions from the account. That includes both your original contributions and their earnings.

Both types of IRAs allow you to avoid paying taxes each year on the capital gains or other income your account generates. But Roth and traditional IRAs differ significantly in how those gains are treated when you withdraw them from the account.

When You Withdraw the Money

With a traditional IRA, the tax is merely deferred, and you will have to pay taxes on your contributions and any gains, at your ordinary income tax rates. With a Roth IRA, that money is tax-free, as long as you meet the criteria for a qualified distribution. For example, you must generally be at least age 59 1/2 and have held the account for at least five years. (Note that you can withdraw your original Roth IRA contributions anytime, and tax-free, should you ever need to.)

To be eligible for a tax-free distribution from your Roth IRA, you most generally be at least 59 1/2 and have held the account for five years or more.

As an illustration, suppose you have a mutual fund in a Roth IRA that has grown to $15,000 from your initial contribution of $5,000, and you now want to sell it and withdraw the money from your account. Assuming it's a qualified distribution, neither your $5,000 initial investment nor your $10,000 profit is taxable, and you can do as you please with the full $15,000.

With a traditional IRA, however, your entire distribution would be taxed at your marginal tax rate for ordinary income. So if you're in the 22% marginal tax bracket, for example, your $15,000 withdrawal would cost you $3,300 in taxes and net you just $11,7000. Your state might want a piece of that, too.

Meanwhile, if you held the money outside of a tax-advantaged plan, such as in a regular brokerage account, your profit would be taxed at your long-term capital gains tax rate. If that's 15%, you'd owe $1,500 in tax.

The Bottom Line

If concerns about the tax consequences have been keeping you from moving money within your IRA, Roth or traditional, don't let it hold you back. But if you're selling a mutual fund in a traditional IRA and plan to withdraw the money, bear in mind that you'll likely owe some tax.