Capital gains taxes have been a notable contributor for the growth of the U.S. economy over the last several decades. By providing investors with the ability to benefit from a lower tax rate for holding an investment more than a year, the capital gains tax has functioned to encourage savings and increase economic growth. The capital gains tax regime only applies to capital assets.

This article will describe, in simple terms, how the capital gains tax regime works, as well as explain how using a Self-Directed IRA or Roth IRA can prove even more tax advantageous. Contributions to IRAs are made with tax-advantaged funds, which allows earnings to grow tax free within the account. Taxes are deferred until distributed, or, in the case of a Roth, no taxes are due on qualified withdrawals.

What Are Capital Assets?

According to the IRS, almost everything you own and use for personal, or investment purposes is a capital asset, such as a home, car, and stocks or bonds.

A capital asset is property that is expected to generate value over a long period of time. In essence, from a tax perspective, a capital asset is all property held by a taxpayer, with the exceptions of inventory and accounts receivable. Using IRAs for capital assets can be tax advantaged, providing benefits like tax-deferred growth or tax-free withdrawals.

Understanding the Capital Gains Tax

Capital gains tax is a type of tax levied on the profit made from the sale of an investment, such as stocks, bonds, or real estate. The tax is calculated based on the difference between the sale price and the original purchase price of the investment. In the context of retirement accounts, capital gains tax can have significant implications for investors.

For traditional IRAs, capital gains tax is not applicable while the investments are held within the account. However, when withdrawals are made, the investor is subject to ordinary income tax on the distributed amounts. On the other hand, contributions to Roth IRAs are post-tax. As a result, these accounts offer tax-free growth and withdrawals, meaning that investors do not have to pay capital gains tax on their investments.

It’s important to understand the tax implications of capital gains tax when investing in retirement accounts. By doing so, investors can make informed decisions about their investment strategies and minimize their tax liabilities.

Capital Gains Taxation Structure

Federal tax law apportions capital gains into two different classes determined by the calendar.

Short-term gains come from the sale of property owned one year or less; long-term gains come from the sale of property held more than one year. Short-term gains are taxed at your maximum ordinary income tax rate, where the maximum tax rate in 2025 is 37%. Whereas most long-term gains are taxed at either 0%, 15%, or 20%. For most people, you will be in the 15% bracket if your income falls between roughly $48,000 and $533,000.

In order to determine whether your capital gains transaction will be subject to the short-term or long-term capital gains tax rules depends on the period of time the taxpayer held the asset.  When figuring the holding period, the day you bought the asset does not count, but the day you sold it does. So, if you bought a capital asset, such as a piece of real estate, on August 1, 2024, your holding period began on August 2nd. August 1, 2025 would mark one year of ownership for tax purposes. If you sold the asset on that day, you would have a short-term gain or loss. A sale of the asset one day later, on August 2nd, would produce long-term tax consequences, since you would have held the asset for more than one year. The federal income tax rate you pay depends on whether your gain is short-term or long-term.

Related: Self-Directed IRA Real Estate vs. Capital Gains

What Are Capital Losses?

A capital loss is a loss on the sale of a capital asset such as a stock. As with capital gains, capital losses are divided by the calendar year into short- and long-term losses and can be deducted against capital gains, but there are limitations. Losses on a capital investment is first used to offset capital gains of the same type. Hence, short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. Net losses of either type can then be deducted against the other kind of gain.

So, for example, if you have $4,000 of short-term loss from a stock investment and only $1,000 of short-term gain from a stock investment, the net $3,000 short-term loss can be deducted against your net long-term gain (assuming you have one). 

If a taxpayer engages in numerous capital asset transactions in a particular year, the end result could be a mix of long- and short-term capital gains and losses If you have an overall net capital loss for the year, you can deduct up to $3,000 of that loss against other kinds of income, including your salary and interest income, for example. Any excess net capital loss can be carried over to subsequent years to be deducted against capital gains and against up to $3,000 of other kinds of income. If you use married filing separate filing status, however, the annual net capital loss deduction limit is only $1,500.

When Do You Owe Capital Gains Taxes?

The federal income tax rules do not tax all capital gains. Rather, gains are taxed in the year an asset is sold, regardless of when the gains accrued. Unrealized, accrued capital gains are generally not considered taxable income. For example, if you bought a capital asset for $10,000 five years ago, and it’s worth $30,000 now and you sell it, your taxable capital gain would be $20,000 in the current year, and zero in the previous years. Additionally, the timing of when you withdraw money from an IRA can affect your tax liability and potential penalties.

Avoiding Capital Gains Tax

Capital gains tax can have significant implications for investors. However, there are strategies that can help minimize or avoid capital gains tax.

One strategy is to invest in tax-loss harvesting, which involves selling securities that have declined in value to offset gains from other investments. This can help reduce the overall tax liability.

Another strategy is to invest in tax-deferred accounts, such as traditional IRAs or 401(k)s. These accounts allow investors to defer taxes on their investments until withdrawal, which can help minimize capital gains tax.

Investors can also consider investing in tax-free investments, such as municipal bonds or tax-free mutual funds. These investments offer tax-free income, which can help reduce the overall tax liability.

Capital Gains and Mutual Funds

A mutual fund is a professionally managed investment fund that groups money from many investors to purchase securities. Based on the mutual fund rules, mutual funds that accumulate realized capital gains throughout the tax year must distribute them to shareholders.

Many mutual funds distribute capital gains right before the end of the calendar year, even if they are short-term capital gains. For tax conscious investors, owning a mutual fund in an IRA or 401(k) plan would prove more tax advantageous because a retirement account generally does not pay any tax on income or gains generated on a capital asset investment. Additionally, funds can be withdrawn from a Roth IRA without incurring a 10% penalty if used for qualified education expenses.

Taxation of Traditional and Roth IRAs

Traditional and Roth IRAs are subject to different tax rules. Traditional IRAs are tax-deferred, meaning that contributions are made with pretax dollars, and withdrawals are taxed as ordinary income. Roth IRAs, on the other hand, are funded with after-tax dollars, and qualified withdrawals are tax free.

For traditional IRAs, the tax implications are significant. Contributions are tax-deductible, but withdrawals are subject to ordinary income tax. This means that investors will pay taxes on their withdrawals in retirement, which can impact their overall tax liability.

Roth IRAs, however, offer tax-free growth and withdrawals. Since contributions are made with after-tax dollars, investors do not have to pay taxes on their withdrawals in retirement. This can provide a significant tax advantage, especially for investors who expect to be in a higher tax bracket in retirement.

Self-Directed IRAs & Capital Gains in Retirement Accounts

In other words, an IRA would not be subject to ordinary income tax or any capital gains tax on income or gains allocated to an IRA, irrespective of holding period. However, early withdrawals from IRAs before age 59½ typically incur a 10% penalty and may also trigger income taxes.

For active stock or crypto traders, using a Self-Directed IRA is a huge tax advantage. Most active traders will not hold the underlying asset for longer than twelve months, meaning the gains from the capital investment would be subject to short-term capital gains, which is taxed based on the taxpayer’s ordinary income tax rate. Whereas, if the investor used an IRA to make the investments, no tax would be due on any of the trading gains. The same principles would apply if the IRA invested in real estate. Traditional IRAs allow for a tax deduction on contributions, but withdrawals are subject to ordinary income tax.

The one drawback for using a Self-Directed IRA versus personal funds to make a capital investment is that by using personal funds one can benefit from depreciation and other deductions, as well as pass-through tax losses. Although, depreciation recapture could be owed on a sale.

In addition, the sale of the asset would be subject to capital gains. Compared to owning the real estate in an IRA, where the IRA would not benefit from any losses, and IRA distributions are subject to ordinary income tax. Though, an IRA would be able to take advantage of the power of tax deferral and defer all income and gains until a later time when a taxable distribution is taken. Of course, a Roth IRA would trump the pretax IRA option and likely also the personal fund option since all qualified Roth IRA distributions are without tax.

Self-Directed IRA Rules and Regulations

Self-Directed IRAs offer investors the flexibility to invest in a wide range of assets, including real estate, cryptocurrencies, and private companies. However, there are specific rules and regulations that govern these accounts.

One of the key rules is that Self-Directed IRAs must be held in a separate account from other retirement accounts. This means that investors must establish a new account specifically for their Self-Directed IRA investments.

Self-Directed IRAs are subject to the same contribution limits as traditional IRAs. This means that investors can contribute up to $7,000 in 2024 and 2025, or $8,000 if they are 50 or older.

Investors must also be aware of the prohibited transaction rules, which prohibit IRAs from investing in certain assets, such as life insurance contracts and collectibles, and engaging in transactions involving a disqualified person.

Whichever way you decide to invest, you should know the ramifications of both types of capital gains, and you can potentially use losses to offset any taxes incurred.