Come retirement, you can withdraw your Roth IRA funds, and your contributions and earnings won’t count as taxable income. This is because you make contributions to a Roth IRA with money that is already taxed. Roth IRAs are often appealing to people who are newer in their careers and whose income tax rate is likely on the lower side. If you’re investing in a Roth IRA to help prepare for retirement, you may want to know more about how dividend investing works with this type of savings account and if it’s the right path for you to take. Keep reading to learn the basics of dividend investing and how Roth IRA dividends are taxed.
How Dividends Work With Roth IRAs
With a Roth IRA, you contribute money you already paid taxes on. Those contributions have the chance to earn money when they’re invested. You can withdraw your contributions tax-free at any time. But you’ll have to wait until you’re at least 59 1/2 and have had the Roth IRA open for at least five years to withdraw your earnings from investments without paying taxes. This doesn’t include dividends though. If you earn dividends in a Roth IRA, you can have your IRA provider disburse the dividends to you, or you can opt to reinvest them in your Roth IRA.
Dividend Investing In a Roth IRA
Dividend investing involves buying stocks that pay a percentage of their company earnings to shareholders usually on a quarterly basis. You can collect dividends from your stocks without selling stocks. You can continue to own the shares while collecting dividends in cash every year. You can also reinvest your dividends, using them to buy more shares of stock. Even if you sell your shares for the same or less than you purchased them for, you still have a chance to turn a profit if you collect enough dividend earnings. Dividends are usually reported to you on Form 1099-DIV, but you likely won’t receive one from your Roth IRA. When pursuing dividend investing through a Roth IRA, you should keep the following tips in mind.
Choose the Right Stocks
There’s no way to guarantee a good stock investment but there are certain factors you can consider while selecting a dividend stock for your Roth IRA. One of them is the type of dividend a company offers. You can choose between a cash dividend (you receive dividend payments in cash), a preferred dividend (you will be paid cash dividends before common stock shareholders), and a dividend reinvestment program (your cash dividends are automatically reinvested in more shares of the same company stock). If you don’t specifically elect to receive your dividend distributions in cash, you will typically be automatically enrolled in a dividend reinvestment program (often called a DRIP).
Pay Attention to Timing and Reliability
When choosing dividend stocks you’ll want to look for a stock that distributes dividend payments on a regular schedule whether that be monthly, quarterly, semiannually, or annually. Take into account how reliable a company is when it comes to offering dividends. For example, Proctor and Gamble has had a history of paying dividends consecutively for 131 years since its incorporation in 1890. The company also increased its dividends every year for 65 years. Do some research into the history of a company’s dividend payment schedule and the typical yield of those payments.
Understand How Taxes Work
While dividend income held in a Roth IRA isn’t taxable, if you are investing in dividend stocks outside of a Roth IRA, say in a typical brokerage account, it is taxed differently. This is why a Roth IRA can be a smarter choice than a brokerage account when it comes to dividend investing. You won’t pay taxes on gains, interest, or dividends when withdrawing the money after age 59 1/2 and owning the Roth IRA for more than five years. Your savings have the opportunity to grow through the power of tax-advantaged compounding. For example, let’s say you make a contribution of $6,000 a year to your Roth IRA. You do this for 30 years and have an average annual return of 6%. After 30 years, you’d have $508,810 in your Roth IRA. Since you already paid tax on the money you contributed during those 30 years ($186,000), and because you’re now over 59 1/2 and have owned the Roth IRA for more than five years, you don’t have to pay taxes on any of this money. If you did the same thing in a regular brokerage account, you’d have to pay long-term capital gains taxes on your earnings after 30 years (0%, 15%, or 20%, depending on your income).
How To Avoid Penalty Taxes and Other Costs
While Roth IRAs are tax-free, there are mistakes that can arise when making nonqualified withdrawals or excess contributions that would impose penalty taxes.
Nonqualified Withdrawals
A qualified withdrawal (also known as qualified distribution) from a Roth IRA is one that is made under the following circumstances:
Distribution is made after five years of the account being contributed toDistribution is made when you are 59 ½ or olderYou are disabledYou were affected by a qualified disasterYou meet certain first home exemptions
Excess Contributions
Making excess contributions to your Roth IRA can also lead to penalties and taxes. Excess contributions are subject to an additional tax of 6%. If you withdraw your excess contributions by April 15 of the following year, you won’t be required to pay that penalty tax. Double-check to make sure you know what the new contribution limit is for the year and plan to contribute accordingly.
