Making trades in an IRA

Because an IRA is an individual retirement account, many people use them for long-term, buy-and-hold style investing. This makes sense since IRAs let investors take advantage of tax-deferred or tax-free compounding and likely won’t be accessed for some time. However, the tax advantages have a related benefit: When you make a trade in an IRA, there are typically no direct tax consequences as there would be in a brokerage account. This makes it possible to take a more active approach to managing an IRA portfolio than many investors realize.

A more active approach might allow you to adjust asset allocations more often, react more closely to market changes, buy or sell individual investments more freely, or pursue potential opportunities when you spot them.

Of course, you should carefully consider the risks and potential downsides of a more active approach, especially with assets that you may be relying on for retirement. Depending on your trade decisions and frequency, you could easily find yourself taking on more risk than with a less active strategy. This is one reason why many investors reserve their more active investing for non-retirement portfolios. Your time horizon is also a big factor, especially if it’s on the shorter side. If you’ll be retiring soon, you may not have enough time to recover from trading decisions that go against you.

Although IRAs are subject to several rules and regulations that don’t apply to brokerage accounts—e.g., contribution limits, eligibility requirements, and mandatory withdrawals—they enjoy one big advantage when it comes to taxes.

Profits made from short-term trades (investments held less than a year) in a brokerage account will typically be taxed in the year they occur at the same rate as ordinary income. You have to take that into account when deciding if and when to sell in a brokerage account. The taxes you would owe on a profitable sale might prevent you from selling one security and buying a different one that you prefer.

On the other hand, profitable trades in an IRA don’t incur capital gains taxes, whether long- or short-term. Investment earnings made in a traditional IRA are taxed as ordinary income when they are withdrawn (typically in retirement), while qualified withdrawals of earnings made in a Roth IRA are tax-free.

From a portfolio management perspective, this means you can generally buy and sell securities in either type of IRA without worrying about the tax consequences of the transactions. One important exception is publicly traded partnership investments held in an IRA, where an investor may incur unrelated business income tax (UBTI) liability. Still, in an IRA there are fewer obstacles to selling investments that you no longer want and buying others that you prefer, or to making more frequent trades. And of course, any gains you potentially make can grow with tax-free compounding. (Remember also that dividends and interest earned in an IRA enjoy the same tax advantages as capital gains.)

Note that there are limitations to the kinds of trades you can make in an IRA compared to a brokerage account. Most importantly, you can’t use margin. That means you can’t short sell stocks, and any options strategies that involve so-called “naked” short positions are also off limits. Furthermore, if you incur significant losses on trades, an IRA’s contribution limits might prevent you from replenishing your portfolio with more cash. And of course, any trading restrictions imposed by mutual funds still apply in an IRA.

Although both types of IRAs allow you to make trading decisions that have different tax implications than they would in taxable accounts, there are important differences between the two IRA types.

As we mentioned, in a traditional IRA, taxes on investment earnings are generally deferred until you withdraw the money in retirement, when it’s taxed as ordinary income. Your eligible contributions may be tax-deductible for the year for which you make them.

With a Roth IRA, you make contributions with after-tax money (i.e., contributions are not tax-deductible), but earnings are not taxed at all as long as you follow withdrawal rules. This is a benefit compared to other kinds of accounts that are also funded with after-tax dollars (like a brokerage account), and it’s why some people consider a Roth IRA to be a particularly attractive option.

Other differences between the two types of IRAs include eligibility and mandatory withdrawal requirements, and it’s important to weigh all these factors.

Taking a more active approach to managing an IRA portfolio and making trades in the account is not for everyone. Investors have to be careful not to take on more risk than they intend to, or more than is appropriate for their strategy, goals, and investing time horizon. But an IRA removes one major obstacle to more active investing, while also offering the potential for growth without the drag of annual capital gains taxes.