Individual retirement accounts (IRAs) provide taxpayers who have earned compensation, such as salaries, wages, tips, commissions and bonuses, with a means of setting aside a portion of those earnings in a tax-advantaged account toward their retirement years.
According to the U.S. Securities and Exchange Commission, IRAs come in a variety of forms. These include SEP, SIMPLE, Roth, and traditional IRAs. However, the two primary types of types of individual retirement accounts are the traditional IRAs and Roth IRAs.
Each type of IRA offers significant, though different, tax advantages. However, both types allow investments inside the account to grow without incurring a current income tax obligation.
Explanation of Capital Assets
According to the IRS, almost everything you own for either investment purposes or personal use is a capital asset. Personal capital assets may include your home, your car, your laptop computer and your lawn mower. Investment capital assets may include any stocks or bonds you own, rental property and funds in your 401(k) at work. On the other hand, investment capital assets may also include investments in your IRA.
Short-Term and Long-Term Capital Gain
You may experience either a capital gain or a capital loss when you sell a capital asset. If you sell a capital asset for more than you paid for it, you typically have a capital gain. However, if you sell a capital asset for less than you paid for it, you typically have a capital loss.
The Internal Revenue Service considers all capital gains to be income, which you must report when you file your federal income tax report, regardless of whether the capital gain resulted from the sale of a personal or investment asset. However, how long you have owned the capital asset will determine whether the IRS consider the capital gain or loss as short-term or long-term.
Long Term vs. Short Term Capital Gains Tax
The IRS considers any gain from the sale of a capital asset that you held for one year or less to be a short-term capital gain. On the other hand, gains on capital assets that you held for longer than one year are considered long-term capital gains.
The income tax rate on long-term capital gains is typically lower than the income tax rate on short-term capital gains. So, it’s important to consider the tax rates you will pay when selling a capital asset. Sometimes, it may be better to hold onto it for a while longer.
IRA Capital Gains and Exceptions
Capital assets held in an individual retirement account are allowed to grow tax-deferred as long as the assets remain in the IRA, regardless of whether the account is a traditional IRA or a Roth IRA.
You need to know that all income produced by the capital assets in an IRA are treated the same for income tax purposes, regardless of whether the income resulted from interest, dividends, long-term capital gains, short-term capital gains or tax-free payments from a municipal bond. Therefore, the IRS says that taxes due to capital gains will be deferred until distribution.
However, all withdrawals from a traditional IRA are taxed as ordinary income, regardless of the type of gain that occurred inside the IRA. And the income tax rates tend to vary from one year to another. However, they are generally higher than long-term capital gains rates.
It is also worth noting that qualified withdrawals of all gains produced in Roth IRA are free from federal income taxes, regardless of the type of gain. However, the IRS says that nonqualified distributions of all gains produced in a Roth IRA are taxed as ordinary income and may also be subject to a 10 percent income tax penalty.
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.