How Are Roth IRA Dividends Taxed?

Dividend investing with a Roth IRA can help cut your taxes and grow your savings

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A Roth IRA is a helpful tool when it comes to saving for retirement thanks to the fact that when you withdraw the funds at retirement your contributions and growth won’t count as taxable income. You make contributions with post-tax earnings which is why it’s appealing to contribute to a Roth IRA when you’re newer in your career and your 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.

Key Takeaways

  • Roth IRAs allow you to invest post-tax income and withdraw your savings and earnings tax-free if you meet certain criteria.
  • You can pursue dividend investing, which is investing in stocks that regularly disperse dividends, through your Roth IRA.
  • You can choose to receive dividend distributions or can enroll in a dividend reinvestment program. 

Roth IRAs Are Tax-Free

With a Roth IRA, you contribute with earnings you already paid taxes on. Those contributions have the chance to earn money when they’re invested. 

Roth IRA earnings are totally tax-free at the time of distributions as long as you meet certain rules when you withdraw them. 

If a distribution made from your Roth IRA is a qualified distribution then you won’t need to pay a tax or penalty (this includes dividend income and capital gains withdrawals).

How Dividend Investing Works With a Roth IRA

Dividend investing involves buying stocks that are known for regularly dispersing dividends. Companies distribute dividends to give their shareholders a part of the profit they make.

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. This style of investing also allows you to enjoy your earnings even before you sell your stock.

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 (you will reinvest your cash dividends 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

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, as of January 2022, Proctor and Gamble had a history of paying dividends consecutively for 131 years since its incorporation in 1890. The company also has 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. 

Qualified dividends are taxed as long-term capital gains and nonqualified dividends are taxed at your ordinary tax rate.

This is why a Roth IRA can be a more financially beneficial choice than a brokerage account. You won’t pay taxes on gains, interest, or dividends when withdrawing the right way and while you wait to be able to withdraw, your savings have the opportunity to grow through the power of tax-advantaged compounding

For example, if you were to make a contribution of $6,000 a year, at a 24% cumulative tax rate with a 6% annual fixed rate of return, the end results would look differently if you invested in a normal brokerage account instead of a Roth IRA for 30 years.

In the taxable brokerage account after 30 years you would have $386,648. In a tax-advantaged Roth IRA account you would end up with $502,810.

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 to
  • Distribution is made when you are 59 ½ or older
  • You are disabled
  • You were affected by a qualified disaster
  • You meet certain first home exemptions

If you make a nonqualified withdrawal, you risk being charged a potential 10% early withdrawal penalty tax.

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 (for example, April 18, 2022, for 2021 contributions) 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. 

Frequently Asked Questions (FAQs)

What should you do with the dividends you receive in your Roth IRA?

If you choose to pursue dividend investing, you have the option to receive your dividends in cash and can choose to invest that cash held in your Roth IRA in a different investment or you can choose for any dividends to be a part of a dividend reinvestment program that reinvests your dividends into the same stocks they came from.

Do dividends count toward your Roth IRA annual contribution limit?

Dividend income is not considered to be a form of compensation or earned income and doesn’t count towards the contribution limit when investing in a Roth IRA. Being able to grow your contributions is one of the main benefits of investing in a Roth IRA.

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