In 1974, Congress created individual retirement accounts (IRAs) as tax-efficient vehicles for retirement savings. Even as they have changed and evolved, IRAs continue to fulfill that core mission. Real, practical distinctions exist between keeping money in an IRA and a "stock account," typically held at a bank or brokerage. The IRS treats each type of investment vehicle differently from a tax standpoint.
Generally speaking, taxable stock accounts do not provide any type of tax break. With an IRA, however, the IRS provides investors with true tax perks. If you own a traditional IRA, the IRS allows you to deduct your contributions, up to an annual limit, from your taxable income. While a Roth IRA does not provide this benefit, you can withdraw the entire account value, including earnings on original contributions, tax-free, once you turn age 59 1/2 and have held your Roth for a minimum of five tax years.
Capital Gains and Dividends
When you sell a stock for a profit inside a stock account you must report this "capital gain" to the IRS and pay taxes on it. If a stock you own in a stock account pays out a dividend, the IRS requires that you pay taxes on this type of earning as well. The same rules apply to mutual funds held in taxable accounts. Capital gains and dividends realized in IRA accounts enjoy tax-deferred status. This means that you do not have to pay taxes on earnings in an IRA account as they happen. You only pay taxes on capital gains and dividends when you remove money from your IRA. In the case of a Roth IRA, you may never pay taxes on these earnings, assuming you follow the IRS's 59 1/2 and five-year rules.
If you need to access your money in an IRA before you turn 59 1/2, the IRS generally charges a 10 percent tax penalty. Refer to IRS Publication 590 to see if you qualify for an exception to this rule. No such rules apply to taxable stock accounts. When you remove money from them, you do not have to pay any type of tax penalty. Taxes only come into play when you sell securities and collect dividend payments.
To contribute to an IRA, you typically need to collect some form of taxable compensation, often from employment. You also need to qualify to open and/or contribute to an IRA. You may qualify for a traditional IRA, but not a Roth or vice versa. The IRS may also place limits on how much money you can contribute on the basis of your income and participation in workplace retirement plans. No such restrictions exist for taxable stock accounts. Fewer tax- and income-related rules and regulations apply to these types of accounts.