Traditional IRA Dividends
If you have reached the maximum for contributions to a workplace retirement plan, the age-old consensus from investment advisers is to put as much as the Internal Revenue Service (IRS) allows into an IRA. You will have to determine for yourself which type of IRA--Roth or traditional--is best for you. If you go the traditional route, take note of how the IRS handles earnings, including dividends, that accumulate in your account.
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Types
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Dividends are just one type of earnings you can accumulate in a traditional IRA or other type of investment account. Some companies set aside a portion of their profits and divide them up between stockholders in the form of a dividend. As the Securities and Exchange Commission (SEC) points out, if you own a mutual fund, which can include several stocks, the fund distributes dividends to you. The same protocol applies to capital gains, interest and other types of earnings generated by your investments.
Function
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In a traditional IRA, you generally have two options for handling dividend payments. The firm you hold your IRA with can distribute them as cash in your IRA account. You can also, as the SEC explains, reinvest dividends into new shares of the stock or mutual fund that produced them. With taxable accounts, you can receive a check every time a dividend is paid. In a traditional IRA, you would not want to exercise this option prior to age 59-1/2 because the IRS considers this an early withdrawal, or distribution, that is subject to federal income tax.
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Benefits
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The primary benefit of receiving dividends and other earnings inside a traditional IRA account is tax deferral. When you hold a taxable investment account, the IRS taxes your earnings, including dividends, on a yearly basis. In a traditional IRA, the earnings are not taxed until you take them out.
Considerations
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If you plan on loading your IRA with dividend-producing stocks or mutual funds, you have no worries if you are a long-term, buy-and-hold investor. Bill Mann of The Motley Fool offers some words of caution, however, if you plan to trade stocks or other securities frequently inside your IRA account. When you lose money on stock or other types of trades in a taxable account, you are able to deduct a portion of your capital losses from your taxable income at the end of the year. The IRS does not provide this benefit with an IRA. If you execute a losing trade in an IRA, the money, all of it, is gone, without the possibility of a tax deduction from Uncle Sam.
Comparison
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To understand how the IRS handles dividends in a traditional IRA, it is helpful to know how a Roth IRA differs from a traditional one. Your traditional IRA contributions are tax-deductible, meaning you can deduct eligible contributions from your taxable income annually, effectively lowering your federal tax bill. When you take money out of a traditional IRA, however, the IRS taxes the entire amount, including earnings and dividends. In a Roth IRA, your original investments are after-tax, non-deductible, earned income, but all withdrawals, including earnings, that occur at age 59-1/2 and after are tax-free.
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