Two important factors in developing a sound investment portfolio is diversification of assets and professional management of funds. Most individual investors don't have enough fund or time to develop a properly diversified portfolio. However, mutual funds provide the twin benefits of diversification and professional management. Investors can gain the additional benefit of tax deferral of gains if they buy or sell mutual funds inside a individual retirement account.
You cannot contribute shares of a mutual fund into your individual retirement account. IRAs can only be funded with cash or cash equivalents. You can purchase a wide variety of investments, including mutual funds, with money inside your IRA. You can deduct contributions to a traditional IRA from your income when you file your federal income tax return. You cannot deduct contributions to a Roth IRA.
Income taxes are deferred on any income produced by investments inside an IRA for as long as the funds remain in the account. All income received from investments within an IRA is treated the same for income tax purposes, regardless of whether the income was interest, dividends, royalties or capital gains. If you purchased shares of a mutual fund in your IRA, then later sold those shares, neither the gain or loss from the sale would be a reportable or taxable event.
Traditional IRA Withdrawals
The Internal Revenue Service treats all funds withdrawn from a traditional IRA the same, and all withdrawals are taxed as ordinary income. If you withdraw funds from your traditional IRA before you turn 59 1/2 you will be liable for an additional tax penalty of 10 percent of the non-qualified withdrawal. Your withdrawal will be taxed as ordinary income at your then-current tax rate. This is regardless of whether you earned dividends from your mutual fund, or sold the shares of your mutual fund for a profit.
Roth IRA Withdrawals
You can withdraw funds equal to the amount of your contributions to your Roth IRA at any time and for any reason without creating a taxable event. This is because you have already paid taxes on those funds. Earnings that remain in your Roth IRA for at least five years may be withdrawn tax-free once you reach age 59 1/2. Early withdrawals of earnings are taxed as ordinary income, and are subject to a 10 percent tax penalty, regardless of how they were earned. Any gains from the sale of mutual fund shares in your Roth IRA are treated the same as any other type of earnings in your Roth IRA.
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