If you’re a retirement investor looking to trade stocks, you may have no choice but to do so within your IRA: 401(k) plans often don’t allow individual stock trading, and many people aren’t saving enough per year to justify opening a brokerage account (which, in most circumstances, should be prioritized after you’ve maxed out tax-advantaged savings options such as 401(k)s IRAs).
But should you trade stocks in your IRA? Maybe. As with all things investing, it’s important to understand what you’re getting into.
Know the risks of frequent trading
Most retirement investors do well with a buy-and-hold strategy that involves investing in a mix of mutual funds — specifically, low-cost index funds or ETFs — that allow relatively easy diversification. There are still risks here, particularly with equity funds that hold stocks, but it’s less risky than individual trading and requires less work on the part of the investor.
“Unless you’re a highly skilled trader, you’re just not going to come out ahead in the long run by doing the churning of buying and selling,” says Kimberly J. Howard, a certified financial planner with KJH Financial Services in Newton, Massachusetts.
Individual stock trading requires an expertise that many investors don’t have — nor do they have the time and inclination to get it, which entails extensive research into companies and a dedication to following the market.
But if that does sound like something you want to take on, start small, Howard says. “If I have clients who want to trade, I’ll tell them to take a small portion of their portfolio as play money,” she says.
Familiarize yourself with capital gains taxes
When you sell an asset — including a stock — for more than you paid for it, you may be subject to capital gains taxes.
Long-term capital gains tax rates, which are applicable when the asset is held for a year or longer, are much lower than those for ordinary income, topping out at 23.8%. But more important to frequent traders are short-term capital gains, which apply on assets held for less than a year and are taxed at the same rate as ordinary income.
Capital losses can be used to offset gains, so if you sell a stock at a $500 profit, and another at a $400 loss, you’ll have realized capital gains of only $100. If your losses exceed your gains, the difference is tax deductible, up to a limit of $3,000 per year.
Why does this matter? Because the account in which you make the trades can determine whether you pay those taxes now, later or … never.
Understand how IRA accounts are taxed
In a standard brokerage account, you’ll report any capital gains and losses on your annual tax return. But IRAs are treated differently, says Ed Slott, an IRA expert and creator of IRAhelp.com.
“You can have unlimited transactions in an IRA and never have to worry about taxes,” Slott explains. “Not only that, but none of those stock trades are ever reported, because gains or losses aren’t realized within the confines of an IRA or a Roth IRA.”
That’s because Roth and traditional IRAs are tax-advantaged retirement accounts, though they’re structured differently: A traditional IRA offers an immediate tax deduction on contributions, but distributions are taxed in retirement. A Roth IRA has no immediate tax deduction, but distributions are tax-free.
That means both accounts allow you to avoid paying any taxes on investment earnings now, as long as the money stays within the account, Slott says, and a Roth IRA allows you to avoid paying those taxes altogether.
“You could have $1 million gains on a stock in an IRA and it’s not taxable while the money is in the IRA,” Slott explains. “With a Roth IRA, everything is tax-free.”
Weigh your account options
In a traditional IRA, you’ll be deferring taxes until retirement, at which point, you’ll pay ordinary income taxes on distributions. Sure, you might miss out on the long-term capital gains discount, but you also won’t incur short-term capital gains — key for regular traders — and you’ll kick all taxes down the road, which is generally considered a smart tax strategy.
But the Roth IRA is the real winner here: If you trade in that type of account, you’ll avoid paying taxes on investment earnings, period. No capital gains taxes, no ordinary income taxes on earnings, as long as you follow the rules for withdrawals.
If you’re eligible for a Roth, which carries income restrictions, that makes this a no-brainer.
The bottom line
Trading, as mentioned, is risky, particularly with retirement funds, which are designed to grow over a long time horizon. You don’t need to make big gambles to maximize returns when you have compound interest on your side.
But if individual stocks are your investment of choice, you should use a Roth IRA to trade them. If you’re not eligible for a Roth, a traditional IRA is the best backup choice.
More from NerdWallet:
- 3 Online Stock Trading Pitfalls to Avoid
- Are You Paying Too Much in Online Broker Commissions?
- The Best IRA Account Providers
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