There's a world of difference between the rock-hard suspension of a Porsche 911 and the comfortable, sciatica-friendly ride of your grandfather's boat-sized Cadillac. In the investment world, you'll find the same variation between stocks. Investing in volatile stocks can accelerate your portfolio's growth, but you'll hit some serious bumps along the way.
Stable companies offering regular dividends aren't as sexy, but over time the combination of capital gains and dividend income can be surprisingly powerful – just like Grampa's Caddy. Traditional and Roth IRAs treat dividends differently, so keep your dividend stocks in a Roth IRA when possible.
Due to the IRS treatment of dividends versus regular income, it is a good idea to use a Roth IRA for your dividend stocks to reduce your taxes in the long run.
Dividends in an IRA
There are two primary reasons to buy dividend stocks. One is to treat the dividends as immediate income. The other is to treat them as a way to speed the growth of your portfolio. In the early years, income from your IRA isn't a factor, but growing your portfolio certainly is.
Remember, your IRA has contribution limits. If you tell your broker to re-invest your dividends by using them to purchase additional shares, this magnifies your limited investment. Those shares generate more dividends, which in turn can be used to purchase more shares, which generate more dividends. The cumulative effect over decades can be substantial.
Tax-Deferred Versus Tax-Free
Your dividends and the rest of your portfolio can grow for decades in your IRA, sheltered from taxation. However, traditional and Roth IRAs have one significant difference.
Contributions to your traditional IRA are considered pre-tax dollars since you got to deduct them from your income at tax time. You'll pay income tax, theoretically at a lower rate than now, when you withdraw an income.
Your Roth IRA is funded with after-tax dollars, so once you retire, the income you take from it won't be taxed again. That's why your traditional IRA is called "tax-deferred," while a Roth IRA is genuinely "tax-free."
Effects on Taxation
Under U.S. tax law, dividends are taxed at a lower rate than regular income or interest income. As of 2019, tax rates on regular income could go as high as 37 percent, while dividends are taxed at only a max of 23.8 percent.
If you retire with a traditional IRA stuffed to bursting with capital gains and dividends, the IRS has bad news for you. It's all taxed at your current rate as ordinary income. The preferential treatment given to dividends is gone.
How a Roth IRA Works
With a Roth IRA, you don't have the benefit of a tax deduction when you make your contributions, but the income you draw from your IRA is not taxed. Instead of losing the benefit of preferential taxation on your dividend income, you have the greater benefit of paying nothing.
Roth IRAs have the secondary benefit that you can withdraw your contributions at any time without penalty. The gains on your contributions, including dividends, are taxable unless they've been left in the IRA for at least five years. If you withdraw a portion of your gains before you're 59 1/2, you'll also pay an additional 10 percent tax penalty.