Most investors focus on minimizing fees from their brokerages. If you made four trades a month (two buys and two sells) over 30 years, that comes to $14,400 at $10 a trade.
If you get serious and shop around for a cheaper brokerage, you could reduce trading costs to $5 a trade (as an example). This would result in savings of $7,200 over the course of your investing career.
A $100,000 account returning 9% a year with a 50% turnover rate will incur taxes of $176,272 over 30 years (using a 20% long-term capital gains rate for all gains).
This article takes a look at how a Roth IRA can greatly reduce your tax bill – and give you more money in retirement.
A Roth IRA is a retirement account that allows individuals to set aside after-tax income to compound in a tax-free account.
You put after-tax money into your Roth IRA (called a contribution). You take money out of your Roth IRA without paying additional taxes to fund your retirement (called a distribution).
Source 2: Amount of Contributions You can make in 2016 from the IRS.
Failing to meet the following distribution rules will result in paying a penalty tax (in most cases) of 10%. A list of qualified exceptions to the tax penalty can be found here (under “Exceptions”).
The advantage of a Roth IRA is that it allows your investments to grow tax free.
In normal accounts (nonretirement accounts), qualified dividends are taxed at the long-term capital gains rate of 20%. Nonqualified dividends are taxed at 39.6% (both numbers are for the highest income tax bracket).
Instead of paying taxes on these dividends every year, dividend payments are left in the Roth IRA. They can (and should be) reinvested either into the stock that paid them (called DRIPing) or into other high quality dividend growth stocks.
The below shows the account value of $10,000 invested in a stock that grows at 6% a year and pays a 3% a year dividend (dividends are reinvested). A 20% dividend tax rate is assumed.
Remember, dividend income in a Roth IRA is not taxed. It does not count toward your annual contribution to the Roth IRA, either.
Roth IRAs can save significantly more money by eliminating capital gains tax every year. The higher your portfolios turnover rate (and gains), the greater the tax savings from the Roth IRA versus a normal (nonretirement) account will be.
Traditional IRAs and 401Ks have something called a “required minimum distribution.” You are forced to take a certain amount of money out of your retirement account every year after you turn 70½.
This gives them greater flexibility. Your money is free to compound in a Roth IRA as long as you are alive. Required minimum distributions do not start until after you pass away and your beneficiary gets the Roth IRA.
No required minimum distributions means a longer compounding window and more time to grow your dividend snowball.
If the ultimate goal of your portfolio is to fund your retirement, then a Roth IRA is a good choice.
The tax advantages of a Roth IRA allow you to benefit from the power of compounding without giving Uncle Sam his “fair share.”
Do not fall into the trap of trying to maximize your tax savings at the expense of maximizing your total returns in a Roth IRA. What does this mean?
It means don’t invest in ultra-high dividend-yielding stocks (which carry too much risk) to try to wring every last ounce of tax savings out of the account.
Instead, invest in high quality dividend growth stocks with favorable total return prospects. The 8 Rules of Dividend Investing will help in:
A brief list of well-known brokerages that offer Roth IRAs is below. Brokerages are sorted in order based on transaction cost.
Fees matter in investing. The less you pay the government (by using a retirement account like a Roth IRA) and the less you pay your brokerage (by minimizing transactions and transaction costs), the more money is left in your account to compound – where it belongs.
Choose the Right Stocks
There’s no way to guarantee a good stock investment but there are certain factors you can consider while selecting a dividend stock for your Roth IRA. One of them is the type of dividend a company offers. You can choose between a cash dividend (you receive dividend payments in cash), a preferred dividend (you will be paid cash dividends before common stock shareholders), and a dividend reinvestment program (you will reinvest your cash dividends in more shares of the same company stock).
If you don’t specifically elect to receive your dividend distributions in cash, you will typically be automatically enrolled in a dividend reinvestment program.
Pay Attention to Timing and Reliability
When choosing dividend stocks you’ll want to look for a stock that distributes dividend payments on a regular schedule whether that be monthly, quarterly, semiannually, or annually.
Take into account how reliable a company is when it comes to offering dividends. For example, as of January 2022, Proctor and Gamble had a history of paying dividends consecutively for 131 years since its incorporation in 1890. The company also has increased its dividends every year for 65 years.
Do some research into the history of a company’s dividend payment schedule and the typical yield of those payments.
Dividend investing with a Roth IRA can help cut your taxes and grow your savings
A Roth IRA is a helpful tool when it comes to saving for retirement thanks to the fact that when you withdraw the funds at retirement your contributions and growth won’t count as taxable income. You make contributions with post-tax earnings which is why it’s appealing to contribute to a Roth IRA when you’re newer in your career and your income tax rate is likely on the lower side.
If you’re investing in a Roth IRA to help prepare for retirement, you may want to know more about how dividend investing works with this type of savings account and if it’s the right path for you to take. Keep reading to learn the basics of dividend investing and how Roth IRA dividends are taxed.
FAQ
Do reinvested dividends count toward your IRA limit?
Are reinvested dividends considered contributions?
Should you reinvest dividends in an IRA?
Do dividends count towards contributions?
