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Dividend-earning stocks and mutual funds can help your retirement portfolio grow more quickly, as long as you reinvest the dividends. But they can be a tax trap when you want to take the money out, especially if you invested your money in a traditional IRA.

The Tax Trap Explained

In a regular investment account, the dividends and capital gains you earn benefit from capital gains tax treatment. This means these earnings could be taxed at a lower rate (from 0% to 20% depending on your income level). For example, if you are in the 10% or 15% tax bracket, you would pay 0% taxes on dividends and long-term capital gains. Those in the 25% to 35% tax bracket would pay just 15% on dividends and capital gains. Those in the highest tax bracket, 39.6%, would pay just 20% on dividends and capital gains.

But when that money is in an IRA, the treatment can be radically different, depending on which type of IRA you have and when you want to withdraw the money.

Before retirement, money in any type of IRA actually avoids taxes. You will not pay any taxes on dividends that are reinvested in either a Roth IRA or traditional IRA and left in that account. “The great benefit of retirement accounts, IRAs and Roth IRAs, is that dividends are not taxed on an annual basis. That is the tax deferral component,” says John P. Daly, CFP®, president, Daly Investment Management, LLC, Mount Prospect, Ill. “With a regular taxable investment account, dividends are taxed every year you receive them.

With an IRA the catch comes when you want to withdraw money. The rules are different depending on which type of IRA you have. Here is how they work for both Roth and traditional IRAs.

Roth IRA Withdrawals

As long as you withdraw money invested in a Roth IRA after the age of 59½ – and you owned that account for more than five years – you will pay zero taxes on the withdrawals, even if the withdrawals include dividends. If you do need to withdraw money prior to 59½, you are required to pay taxes on any gains you withdraw at your current tax rate. You will not have to pay taxes on contributions made to the IRA because that money was taxed prior to making that contribution.

“Withdrawals from Roth IRAs are a little tricky. Before retirement, you will only be taxed on earnings made on top of your contributions. For example, if 80% of your Roth IRA is made up of contributions while the rest is made up of earnings, then only 20% of each withdrawal will be taxed at your income tax rate,” says Mark Hebner, founder and president of Index Fund Advisors, Inc., in Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.”

If you decide to take out money prior to the age of 59½, you may also owe a 10% penalty on any gains you withdraw, unless the withdrawal qualified for a special exception. Special exceptions can include disability, first time home purchase and some other qualified exceptions. Even if you meet the special exception rules, you will need to pay taxes on dividends and capital gains at your current tax rate.

Traditional IRA Withdrawals

Most money withdrawn from a traditional IRA is taxed at at your current tax rate, which could be as high as 39.6%. Any capital gains on the earnings in your IRA account do not benefit from lower capital gains tax treatment; they are taxed at the same rate as regular income.

The only exception to that rule is when you contribute to a traditional IRA using money that has already been taxed (in other words you haven’t taken a tax deduction when making the contribution). But beware of taking this approach: Mixing tax-deferred contributions with taxable contributions in a traditional IRA can be a nightmare to sort out at retirement.

If you take money out before the age of 59½ you may also need to pay a 10% penalty on contributions and gains unless you meet the qualifications for a special exception. (See 5 Secrets You Didn't Know About Traditional IRAs.)

“The idea of being in a lower tax bracket at retirement is why most Americans contribute to a retirement plan. If they can save $25 today and only pay $15 in tax when they retire, they think it is a good deal. The reality can be a wake-up call. Many people are in the same bracket and are now paying tax on every dime of income,” says Morris Armstrong, EA, founder of Armstrong Financial Strategies, Cheshire, Conn.

The Bottom Line

An IRA is a great option to save for retirement. The key is to know the rules for withdrawals before you invest, so you do not face any tax surprises at retirement.

“Tax diversification can be just as important as investment diversification. It’s important to have a mix of taxable, tax-deferred and tax-free investments,” says Marguerita M. Cheng, CFP®, chief executive officer, Blue Ocean Global Wealth, Gaithersburg, Md.

As long as you meet the qualifications for a Roth IRA, that should always be your first choice. You lose the tax break on the contribution, but the long term benefits are generally worth it.

Additionally, “for many Americans...[especially] Millennials, a Roth IRA is the best choice since tax rates will only increase in the future. Although a retiree might benefit with a traditional IRA in the short-term, a Roth will win for the majority. Also, with a Roth IRA you’re not restricted to future uncertain tax rates or required minimum distributions (RMDs),” says Carlos Dias Jr., wealth manager, Excel Tax & Wealth Group, Lake Mary, Fla.

For more, see Traditional and Roth IRAs: Which Is Better For Taxes?, How Much Are Taxes on an IRA Withdrawal? and How are IRA withdrawals taxed?

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