There are two primary ways of making money on stocks. When you buy shares of stock for one price and then sell that stock at a higher price, you have capital appreciation. When the company's board of directors votes to return a portion of the profits generated by the company to the shareholders, you have dividend income. Both capital gains and dividend income are subject to taxation when you file your federal income tax return. You can shelter your stock gains from federal income taxes if you hold the stock in your Roth IRA.
There are two primary types of individual retirement accounts; traditional IRAs and Roth IRAs. Both types of accounts offer tax deferment on income generated within the account, but they also have some significant differences. You can deduct contributions to your traditional IRA, but you cannot deduct contributions to your Roth IRA. Qualified withdrawals made from a traditional IRA are taxed as ordinary income in the year they are withdrawn. Qualified withdrawals from a Roth IRA are free from federal income taxes.
Managing Your Roth IRA
You cannot fund your Roth IRA with merchandise or other assets, such as stocks, bonds, real estate, or oil and gas limited partnerships. You can only fund your Roth IRA with cash or cash equivalents, then you can use the cash in your Roth IRA to purchase assets such as stocks, bonds, etc. You can buy or sell any qualified investment as many times as you wish, within the perimeters established by your IRA trustee, without generating a taxable event. The taxes on any income that is earned within the Roth IRA, including stock dividends, is deferred as long as the income remains in the Roth IRA. The income from dividends may remain in the Roth IRA as cash or you may reinvest them in another asset, such as more stock.
You can withdraw any amount you contributed into your Roth IRA at any time and for any reason without generating a taxable event, since you have already paid income taxes on these funds. Earnings on these funds, including any dividend income generated by stocks in your Roth IRA, must remain in the account for at least five years to be eligible for qualified withdrawal. You can begin taking qualified withdrawals of the earnings portion of your Roth IRA once you reach 59 1/2 years of age. Qualified withdrawals from your Roth IRA are free from federal income taxes and do not need to be reported as income.
All of the funds in your Roth IRA belong to you. You can withdraw all of your funds, including any dividends paid on stocks in your Roth account, at any time for any reason. Withdrawal of earnings before you reach 59 1/2 years of age are considered to be non-qualified. Withdrawals of earnings that have been in your Roth account for less than five years are considered to be non-qualified, regardless of your age. Non-qualified withdrawals from a Roth IRA are taxable at your current tax rate. The Internal Revenue Service will also impose an additional tax penalty of 10 percent of the non-qualified amount.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.