The Internal Revenue Service considers any form of income that you receive to be taxable unless it is specifically exempted from taxation by law. This includes employee compensation, such as wages, salaries, tips and commissions; it also includes investment and savings income, such as dividends and interest. You can shield some of your dividend income from current taxation by buying dividend-paying stocks in your Individual Retirement Account.
A dividend is a distribution of property to you that is paid by a corporation in which you own stock. The most common form of dividend is an ordinary dividend, which is paid in the form of money from the corporation's profits and earnings. Dividends don't have to be money. They may also be paid with additional stock or other forms of property. Regardless of what form the dividend takes, the Internal Revenue Service considers the dividend to be taxable income in the year you receive it.
Individual Retirement Accounts
You must make your contributions to your Individual Retirement Account with money; that is with cash or cash equivalents. Once you have funded your IRA, you can use those funds to purchase a wide variety of investments, including dividend-paying stocks. The earnings inside an IRA are all treated the same, regardless of how they are paid. Dividends, interest, capital gains and all other forms of investment increase are grow tax-deferred as long as they remain inside the IRA. The way these funds are taxed once they are withdrawn depends on which type of IRA they are in.
Traditional Individual Retirement Account
Dividends paid by stocks in your Traditional Individual Retirement Account do not incur a current tax liability while they are in the account. They can remain in your IRA as cash, reinvested in additional shares of the original company or invested into any other non-prohibited security. You can withdraw your funds, including dividends, from your traditional IRA at any time and for any reason. The Internal Revenue Service will tax all withdrawals from your Traditional IRA, including dividend earnings, as ordinary income. If you are younger than 59 1/2 years of age, the IRS will additionally charge you a tax penalty of 10 percent of the amount you withdrew. You must begin taking mandatory withdrawals from your Traditional IRA once you reach age 70 1/2.
Roth Individual Retirement Account
Dividends paid by stocks in your Roth Individual Retirement Account are treated the same as those in a Traditional IRA as long as they remain in your Roth IRA. They do not incur a current tax liability while they are in the account. They can remain in your IRA as cash, reinvested in additional shares of the original company, or invested into any other non-prohibited security. You can withdraw an amount equal to your contributions at any time and for any reason without causing a taxable event, since you already paid taxes on those funds. Earnings produced within your Roth IRA, including dividend income, must remain in your Roth account for at least five years to become qualified for tax-free withdrawal. You may take tax-free withdrawals of your qualified earnings, including stock dividends, once you reach 59 1/2 years of age. Earnings, including stock dividends, that are withdrawn before you reach age 59 1/2 years will be taxed as ordinary income and will be subject to a 10 percent tax penalty. Earnings, including stock dividends, that are withdrawn before they have remained in your Roth IRA for at least five years, regardless of your age, will be taxed as ordinary income and will be subject to a 10 percent tax penalty.
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.