IRAs: More reasons to use an IRA

But does it actually make sense to use your IRA? 2. Taxes.

The key benefit of investing through an IRA, of course, is that any gains have favorable tax treatments: in a traditional IRA, the gains are tax-free when they happen and you pay ordinary income tax upon withdrawals; in a Roth IRA, the gains are entirely tax-free.

This sounds like a slam-dunk positive in favor of angel investing through an IRA. However, the story is not quite that simple.

  • (A) In the traditional IRA, you do not pay capital gains when the assets are sold, but you will pay ordinary income rates when you come to make those distributions. The idea is your income will be lower after retirement, so the rate paid then will be less. (Assuming no changes to future tax rates, which seems a questionable assumption…)

  • (B) If you make a capital gain on an angel deal outside an IRA, there is a good chance the gain will not be taxable (a Section 1202 exemption), or can be deferred and eventually not be taxable (a Section 1045 rollover).

So the comparison is between (A) ordinary income taxes on a hopefully lower income bracket at distribution time or (B) potentially no taxes. (B) is not, of course, guaranteed; but it’s not obvious at all that (A) is better than (B).

If you can use a Roth IRA, the comparison would be easier: no taxes in the Roth IRA vs. potentially no taxes outside. That makes decisions like Max Levchin’s no-brainers!