How do taxes work on a Traditional IRA vs a Roth IRA?

Individual Retirement Accounts, or IRAs, can be great investment tools that allow you to benefit from tax advantages when investing. 

With a Traditional IRA, your investments are funded by “pre-tax” dollars, meaning you haven’t yet been charged taxes on it. With your Roth IRA, the money you contribute to it is considered “post-tax” dollars, meaning you’ve already paid taxes. 

Because of this, with a Traditional IRA, once you withdraw the funds from your account, you will need to pay income taxes on the funds you contributed and capital gains. 

With a Roth IRA, since you’ve already paid taxes on the funds, when you withdraw the funds you will not need to pay taxes on the contributions or the gains. 

Both accounts are subject to an early withdrawal penalty if funds are removed before the age of 59 ½. However, with a Roth IRA, you are able to withdraw the contributions made without tax penalty, meaning the penalty will only apply to any capital gains.

What are capital gains and how are they taxed?

Capital gains are any money (capital) made from keeping your funds invested. 

E.g., if Bart invests $1,000 in the stock market and in two years has $1,200 in his account, he has made capital gains of $200. 

Capital gains taxes are the taxes an investor must pay when selling their holdings.

Short-term capital gains means you’ve decided to sell your holdings after having invested them for one year or less. These gains are taxed as ordinary income, meaning whatever tax bracket you fall into for your income level, this is the rate at which you’ll be taxed.

Long-term capital gains are when the gains you’ve made are on investments held for more than one year. These gains are taxed at rates of 0%, 15% or 20% depending on your income level.

Going back to our example, if Bart takes his money out after 2 years, and makes $80,000 a year, he would be taxed at 15% on his gains of $200. 


Carbon Collective is not a tax advisory and cannot provide tax advice. We strongly recommend talking with your certified tax professional for insights into choosing the best strategies for your specific tax situation and goals.