Here's What Happens When You Score a Profit in a Traditional IRA

An estimated 36% of Americans have an individual retirement account (IRA). And if you're eager to build a retirement nest egg, it could pay for you to open one as well.

IRAs come in two main varieties -- traditional and Roth. There are other types of IRAs that are designed for self-employed individuals and small business owners, but those are less widely utilized.

The upside of saving and investing for retirement in a traditional IRA is that you get a tax break on your contributions. But there's an additional tax benefit to be reaped when you invest in an IRA.

There's no need to worry about a near-term tax bill

When you buy and hold stocks in a regular brokerage account, any time you sell shares at a profit, you have to pay capital gains taxes for that same year. In other words, if you score a $1,000 profit in your brokerage account at any point in 2023, you'll have to reconcile that tax bill in the course of filing your taxes for 2023 (you may not have to actually write the IRS a check for capital gains taxes if you qualify for other deductions or credits, but the liability is still there).

With an IRA, gains in your account work much differently. The beauty of a traditional IRA is that gains in your account are tax-deferred, so you don't face a tax bill on profits year after year. Rather, you pay taxes on those gains in the form of taxable withdrawals.

Let's say you buy $2,000 worth of a given stock, and by the time you retire, it's worth $8,000. That's a $6,000 gain. But that doesn't mean the IRS is going to demand its share of that $6,000 in one fell swoop. Rather, you'll be taxed when you take withdrawals so that over time, you're paying taxes on all of your gains in your IRA indirectly.

Does a traditional IRA make sense for you?

If you want to avoid having to pay taxes on investment gains in your retirement plan, then your best bet is to fund a Roth IRA, where investment gains and withdrawals are both tax-free. But one thing you should know is that Roth IRAs are funded with after-tax dollars, so you won't get any tax benefit out of the money you contribute.

With a traditional IRA, funds you put in serve the very important purpose of exempting some of your income from taxes. And it's that tax break that might make it possible for you to save for retirement in the first place.

That said, if you like the idea of getting a tax break on your retirement plan contributions and you also like the idea of tax-free gains and withdrawals, you could split your savings between a traditional and Roth IRA. There's no rule stating that you can only save in one account versus the other.

You can also take a traditional IRA and convert it to a Roth later on should you decide you want the benefit of tax-free gains and tax-free retirement withdrawals. But when you do this type of conversion, you get hit with a tax bill, so you'll need to plan for it carefully.