How Are Dividends in a Traditional IRA Mutual Fund Taxed?
Dividends are one way that investors see a return on their investments. It's common for mutual funds to pay dividends, particularly if the fund holds dividend-paying stocks. If you own a dividend-paying mutual fund in your traditional IRA, you don't have to do much when the fund pays out a dividend. This is one of the prime benefits of investing in an IRA.
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Definitions
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To understand how mutual fund dividends function inside a traditional IRA, you must first grasp the basics. A mutual fund, as the U.S. Securities and Exchange Commission explains, is an investment, comprised of items such as stocks and bonds. These products are grouped together in a portfolio that investors can purchase a piece of and own shares in. Some stocks pay dividends, a distribution of a company's profit, to their shareholders. If a mutual fund you own contains a dividend-paying stock, you receive a portion of this distribution, as you own the overarching fund.
Benefits
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When a mutual fund you own in your traditional IRA pays a dividend, generally these earnings are reinvested in shares of the mutual fund that produced the dividend or are kept inside the IRA account as cash. The benefit of this is known as tax-deferred growth. If you receive a dividend in a taxable investment account, you must report it to the IRS when you file your taxes and pay the appropriate tax on it. When the dividend is in your IRA, you don't pay tax on it annually.
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Process
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With a traditional IRA, you pay regular income taxes on all distributions, including earnings but only when you decide to withdraw money. You never actually report your traditional IRA dividend income to to the IRS. While your bank, brokerage or mutual fund company --- the most common IRA custodians --- report the dividends your investments earned on your IRA statement, this is merely to keep you informed of the account's performance. The amount you eventually report to the IRS is the total amount of any distributions you take from your traditional IRA, which are taxed at your regular income tax rate.
Expert Insight
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As Dave Kansas of the "Wall Street Journal" contends, owning dividend-paying stocks can be a sound investment strategy. Kansas believes that when conservative investments, such as savings accounts and treasury bills, are paying low interest rates, dividend-paying stocks, while a bit riskier, offer a legitimate chance for a higher return. Kansas advises that if you don't have the stomach for the risks inherent in stock investing, stick with one of the many mutual funds that specialize in dividend-paying stocks. Ask your IRA custodian or financial adviser about purchasing dividend-paying stocks or mutual funds that own these types of stocks for your traditional IRA.
Alternative
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If you own a Roth IRA, there's a good chance you'll never pay taxes on the dividends --- or other earnings such as capital gains or interest --- that your IRA investments produce. As IRS Publication 590 illustrates, as long as you've held your Roth IRA account for five years and are taking a qualified distribution --- a withdrawal after you turn 59 1/2 or an allowable early withdrawal --- the IRS doesn't charge tax on the entire amount of the withdrawal. For some investors, this makes a Roth IRA more attractive than a traditional IRA.
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