How Are Dividends in a Traditional IRA Mutual Fund Taxed?

Mutual funds can be an excellent selection for your traditional IRA. They provide diversification of your assets -- the bedrock of all sound investing -- and they give you professional management of your retirement funds. The stocks in your IRA mutual fund may pay dividends. The good news is those dividends are not subject to current income taxes.

Traditional IRA

The federal government first authorized traditional IRAs in 1974. It allows taxpayers who don't have access to a qualified retirement plan at work to set aside a portion of their earnings toward retirement. Congress later extended eligibility for a traditional IRA to most taxpayers who had earned income. The two primary benefits of a traditional IRA include the tax-deductible contributions and tax-deferred growth of assets. Federal income taxes are not due on money in your traditional IRA until you withdraw them.

Investments

You can open a traditional IRA though a number of financial institutions, such as insurance companies, banks, mutual funds and investments brokerage companies. You can only fund your traditional IRA with cash, but you can buy a wide variety of investments with money inside your IRA, including dividend-paying stocks. Any dividends paid on stocks held inside your IRA become a part of your IRA account. You can use them to buy more stock, or invest them in a different kind of financial product such as a bank certificate of deposit. Earnings on assets held in a traditional IRA, including dividends, are not subject to current federal income taxes.

Qualified Withdrawals

You can start taking qualified withdrawals from your traditional IRA once you reach age 59 1/2 years. The Internal Revenue Service considers these withdrawals from your traditional IRA to be ordinary income, regardless of whether the funds originated as contributions or as earnings on investments. When you file your federal income tax return, you must report the amount of your IRA distribution on Line 15a of IRS Form 1040. Since all traditional IRA distributions are considered ordinary income, any portion of the distribution that came from dividends will be taxed at your then-current tax rate as ordinary income.

Non-qualified Withdrawals

All of the money in your traditional IRA, including any dividend payments received from investments held in your account, belongs to you. You have the option of withdrawing those funds at any time, for any reason. If you withdraw funds from your traditional IRA prior to reaching age 59 1/2, the amount withdrawn is considered non-qualified. The Internal Revenue service will tax these funds as ordinary income at your then-current tax rate, regardless of how the funds got into your account. With the exception of certain hardship instances, the IRS will also charge you a tax penalty equal to 10 percent of the non-qualified amount withdrawn.

About the Author

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.