Some companies return a portion of their profits to stockholders via a schedule of dividend payments. Generally, investors have the option to receive dividend payments as cash or request that their brokerage reinvest dividends into new shares of the stock that generated them. In an IRA, you have both options, however, the type of account you have, your age and other factors dictate the eventual tax consequences associated with IRA dividends.
Before you consider how the IRS treats IRA earnings, particularly dividends, it's important to understand the basics of how the two main types of IRA accounts function. If you own a traditional IRA, the IRS charges regular income tax on any withdrawals you take from the account, regardless of your age or circumstance. In a Roth IRA, you can remove money, including earnings, such as reinvested dividends, tax- and penalty-free provided you have held your Roth account for at least five years and are at least 59 1/2 years of age. Refer to IRS Publication 590 to see if any exceptions to this rule apply in your situation.
In any account, reinvesting dividends allows you to build a larger position in a stock without having to commit additional, fresh capital. In a taxable account, however, the IRS collects income tax on the dividend payments you received in a given year at tax time. If you own an IRA, you benefit from tax-deferred treatment on earnings such as dividends and capital gains. This means that the IRS does not tax dividends annually; rather Uncle Sam calculates the tax due, if any, at the time you withdraw money from an IRA.
With a traditional IRA, the IRS does not distinguish between original contributions and earnings such as reinvested dividends when you take a distribution. The agency simply taxes the entire amount of any withdrawal you take at your regular income tax rate. Roth IRAs work differently. Because you contribute after-tax money to a Roth IRA (you are able to deduct traditional IRA contributions from your income each year), you can remove those original contributions at any time, tax- and penalty-free. If you access Roth money prior to age 59 1/2, before having held the account for at least five years or without an exception to the rule, however, the IRS taxes earnings on those contributions at your regular income tax rate. Imagine you withdraw $15,000 from a Roth IRA prior to turning age 59 1/2 without special exceptions. If your account value at the time is $20,000 and half of it is made up of original contributions, while reinvested dividends comprise the other half, the IRS expects you to pay income tax on the $5,000 of the $15,000 distribution made up of the dividends. The IRS "orders" Roth withdrawals, meaning that original contributions come out first ($10,000 in this example) followed by, in this case, earnings ($5,000 in reinvested dividends in this example).
Early withdrawals from both traditional and Roth IRAs may be subject to the IRS's 10 percent tax penalty. This tax comes in addition to any regular income tax due. Unless an exception applies (refer to IRS Publication 590), you may have to pay the 10 percent penalty on earnings, which may be reinvested dividends, you take from an IRA, including a Roth account.