Why Can an IRA Be a Good Place for Active Investment Strategies?

When people think about an IRA, they often think about what investments to own. But there is another question that can matter just as much: what type of investment strategy makes sense to hold inside an IRA?

This can be particularly important for active investment strategies.

Some active strategies may trade only a couple of times a month. Others may trade almost every day. Because positions are frequently bought and sold, many profitable trades may result in short-term gains rather than long-term gains.

In a regular taxable account, those realized gains can create a current tax bill. That can create what I think of as tax drag: money that otherwise could have remained invested and continued compounding may instead need to be set aside to pay taxes.

An IRA works differently.

Active Trading Inside an IRA

Generally, buying and selling investments inside an IRA does not create a current personal capital-gains tax bill each time a profitable position is sold. In a traditional IRA, taxes are generally deferred until money is distributed from the account. Qualified distributions from a Roth IRA can be tax-free.

That can make an IRA an attractive place to consider holding an active investment strategy.

Consider a simple example.

Suppose an active strategy generates $100,000 in gains during the year, with much of those gains coming from investments held for relatively short periods.

In a taxable account, realizing those gains may create a current tax liability. Inside an IRA, the trades generally don't create a current personal capital-gains tax bill, allowing more of the money to remain in the account and potentially continue compounding.

Over one year, that difference may not seem particularly important. Over many years, however, repeatedly allowing more money to remain invested can potentially have a meaningful effect because those additional dollars also have the opportunity to compound.

The More Active the Strategy, the More Tax Location Can Matter

This doesn't mean frequent trading is inherently better. It simply means that if you have already decided to use an active strategy, where you hold that strategy can matter.

A strategy that rarely trades and holds investments for many years may already be relatively tax-efficient in a taxable account. A strategy that trades frequently and realizes gains regularly may create considerably more tax activity.

This idea is sometimes referred to as asset location: deciding not only what investments or strategies you want to own, but which types of accounts may be better suited to hold them.

Tax Efficiency Doesn't Make an Investment Appropriate

There is an important distinction here.

Just because an IRA can be a tax-efficient place for active trading doesn't mean someone's retirement money should automatically be invested aggressively.

If you depend on your IRA for near-term retirement spending, cannot tolerate significant volatility, or would have difficulty absorbing a substantial decline, those considerations are far more important than the potential tax benefits of active investing.

The appropriate strategy depends on the individual: their age, other assets, income needs, time horizon, risk tolerance, and what they ultimately need the IRA to accomplish.

For someone with a long time horizon who wants higher growth and can tolerate the associated volatility, however, an IRA can offer an additional advantage. An active strategy can pursue opportunities without every profitable trade potentially creating a current personal capital-gains tax bill.

Sometimes investment planning isn't only about what you invest in. It is also about where you invest it.