When you own stocks, you regularly receive payments known as dividends. If you keep your stocks in a regular brokerage account, you must report your dividend income to the IRS in your tax return for the year it is earned. If instead you keep your stocks in a Roth IRA, you may be able to delay payment of taxes on your dividend income or avoid it altogether.
Tax-Deferred Growth
A Roth IRA is a retirement account with a couple of key tax advantages. One is tax-deferred growth. This means that as long as you reinvest your gains within your account, you don't owe any income tax. If your stocks are in a regular brokerage account, dividend income is taxable right away, even if you reinvest it. This gives the Roth IRA a better annual after-tax return than regular stock accounts.
Tax-Free Withdrawals
If you take your dividend income out of your Roth IRA as a retirement withdrawal, your earnings are also completely tax-free. This is a huge tax advantage, as there are very few ways to earn tax-free income in the United States. The IRS says you can start making retirement withdrawals when you are age 59 1/2 or older. It doesn't matter if you are still working.
Early Withdrawals
If you make a withdrawal before you turn 59 1/2, it is considered an early distribution. You can withdraw your contributions early without any tax consequences because you have already paid taxes on them. If you remove earnings before age 59 1/2,, however, you'll owe income tax and a 10 percent penalty on the amount withdrawn.
Penalty Exceptions
There are a few situations in which you can take your investment gains out of a Roth IRA without having to pay the 10 percent penalty. You may do so if you become disabled; if you use the withdrawn funds to pay for college expenses for yourself or a family member; if your medical bills for the year exceed 7.5 percent of your adjusted gross income and you use your Roth IRA earnings to pay the excess; or if you use earnings -- up to $10,000 -- to buy your first home. Even though you avoid the 10 percent penalty for such withdrawals, you must still pay income tax on them.
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Writer Bio
Dylan Armstrong specializes in insurance, investing and retirement planning. He has also worked as a life and health insurance salesman and holds a Bachelor of Science in finance from Boston College.