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.
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.
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.
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 If you remove earnings before age 59 1/2,, however, you'll owe income tax and a 10 percent penalty on the amount withdrawn.
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 You may do so if you become disabled; if you use the withdrawn funds to pay for college expenses for yourself or a family member; if your medical bills for the year exceed 7.5 percent of your adjusted gross income and you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.
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.