One of the main motivations for personal retirement plans is the horror at the idea of trying to survive on your Social Security check. Fortunately, the largesse of the federal government makes it relatively easy to invest for the future through tax-sheltered plans, such as the 401k and traditional or Roth IRAs. However, there are limits on contributions to these plans, and sometimes it's difficult to know whether investment income such as dividends should count toward the limit.
IRAs and Retirement
The purpose of IRAs is to encourage saving for retirement. The government's motivations for allowing their tax-preferred status are pretty transparent. The more citizens who manage to retire comfortably, the less strain there is on the social network. Affluent seniors can afford to pay for their own medical care, and continue to be a source of tax revenues and economic growth in their communities. Foregoing a bit of short-term tax revenue is a small price to pay for the larger social benefit. However, there's a limit to Uncle Sam's generosity. That's why there's a limit on contributions to these tax-advantaged plans.
As of early 2012, the annual contribution limits for IRAs were $5,000 for taxpayers under the age of 50, and $6,000 if you're 50 or older. If your income was lower than the contribution limit, you can only contribute up to the amount of your earnings, or "compensation." The Internal Revenue Service's tax documents spell out what counts and doesn't count as compensation, for purposes of IRA contribution limits. One type of income that's explicitly excluded is dividend income.
Dividends are special payments made by some companies to holders of its shares. They consist of a portion of the company's profits, paid out to investors as a set amount per outstanding share. From the company's perspective, it's a way to remain attractive to investors. From the investor's perspective, it's a way to draw an income that's conservative, but generally higher than the returns on interest-bearing investments, and taxed at a lower level. To maximize the growth of their portfolio, some investors choose to re-invest their dividends in purchasing additional shares in the company, or a dividend-heavy mutual fund.
These re-invested dividends can sharply increase the value of your contributions, over a period of years. If you already maximize your IRA contribution each year, these re-invested dividends can provide a significant increase in the value of your portfolio. The IRS doesn't consider them to be a part of your contribution limit for the year, and they don't have to be declared as such. You should still keep careful records of the dividend income each year, because in some cases you might be able to withdraw them without taxation during your retirement.
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