Growing Funds Faster
Dividend-earning stocks and mutual funds can help your retirement portfolio grow more quickly, so 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.
- Dividends earned in traditional IRAs are not taxed when they are paid or reinvested, rather retirement account withdrawals are taxed at one's current income tax when they are withdrawn.
- Roth IRA funds grow tax-exempt, including the payment of dividends, and so these are not subject to taxation.
- These deferments and exemptions are only valid if you wait until at least age 59½ to withdraw retirement funds.
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 earn less than $40,000, you would pay 0% taxes on dividends and long-term capital gains. Those who earn between $40,001 and $441,450 would pay only 15% on dividends and capital gains. Those who earn more than $441,450 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.
"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 of Daly Investment Management LLC in 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.
How IRA Dividends Are Taxed
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 or any penalty 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 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.
"The idea of being in a lower tax bracket at retirement is why most Americans contribute to a retirement plan," says Morris Armstrong, EA, founder of Armstrong Financial Strategies in Cheshire, Conn. "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."
Owners of a traditional IRA are mandated to begin taking required minimum distributions (RMDs) at age 72.
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 of Blue Ocean Global Wealth in 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 from 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," says Carlos Dias Jr., founder and managing partner of Dias Wealth LLC in Lake Mary, Fla.