This article was updated on May 17, 2016.
If you're saving for retirement -- and you should be -- one of the best tools at your disposal is the individual retirement arrangement, or IRA. These kinds of accounts offer a number of tax benefits for money you save toward retirement. However, along with the benefits, there are some tax consequences that you should be aware of.
Kinds of IRAs and the tax benefits
There are two kinds of IRAs: the traditional IRA, and the Roth IRA. Here are the things they have in common:
- Contribute up to $5,500 (up to $6,500 if you're 50 or over) toward your retirement in 2016.
- Capital gains are tax-free in most cases.
- Dividends received in the IRA are tax-free in most cases.
- Distributions taken before retirement are considered taxable income in most cases, and also assessed an early distribution penalty.
Here's how they differ:
- Traditional IRA distributions in retirement are taxed as regular income, while Roth IRA distributions are completely tax-free.
- Traditional IRA contributions may be deductible from your taxable income the year of contribution, while Roth IRA contributions are never deductible.
- Roth IRA contributions are capped, based on your adjusted gross income, while traditional IRA contributions are not.
We also have a great reason if you want to learn more about which IRA is right for yu,
Tax benefits and consequences for most stocks in IRAs
If you buy or sell shares of a "C" corporation inside an IRA, you won't pay any taxes. Here's an example.
If you buy a stock for $1,000 and sell it for $2,000, that's a $1,000 profit. In a taxable account, that would be added to your income for the year. If you held the stock for less than one year, that's a short-term gain, so you would pay income tax on that $1,000 at the same rate as all of your other regular income, such as your salary at work. This rate is almost always higher than the long-term capital gains tax rate of 15% (or 20% for very high-income earners), if you held the shares for more than one year before selling.
In summary, you would avoid taxes of at least $150 on that $1,000 profit if you held those shares in an IRA.
On the other side of the coin is tax losses. When you sell stocks at a loss in a taxable account, you're able to deduct the losses against your gains, and even against your regular income up to a limit. If you sell a stock inside an IRA at a loss, you don't get that benefit.
A category of stocks with tax consequences for IRAs
Most stocks you'll invest in are so-called "C" corporations. However, there are other stocks out there, such as master limited partnerships -- also called MLPs -- as well as "S" corporations and LLCs, with different rules that IRA investors need to be aware of.
These types of investments typically pay large dividends because of special tax rules that eliminate or greatly reduce the taxes these entities pay. This strategy makes them attractive investments, but it also means that the tax consequences get passed on to the investor. In the case of this select group of stocks, it often results in UBTI, or unrelated business taxable income.
And when you hold shares of this type in a tax-advantaged account like an IRA, it could mean your IRA is subject to paying UBTI. Under current IRS rules, if your IRA earns more than $1,000 in total UBTI in a tax year, you must pay income tax on those earnings. Most people therefore tend to avoid holding these sorts of investments inside an IRA. And while it shouldn't necessarily rule out every potential investment of this type, the cost in taxes may keep these investments from being the best choice for your IRA.
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