Do I Pay Taxes on Qualified Dividends in an IRA?

Dividend Definition

Most individual investors receive qualified dividends, which typically are paid out by U.S. corporations to their shareholders. If you own a dividend-paying stock, you receive a dividend payout for each share you own. For example, if you own 100 shares of a stock that pays a dividend of $1 per share, you receive an annual dividend payment of $100. Most firms split their dividend payment up into quarterly installments. If you own a mutual fund that receives dividends from stocks it owns, you'll receive a distribution from the fund representing your share.

Many people own IRAs to shield themselves from having to directly pay tax on earnings such as dividends. When you hold a stock or mutual fund that pays a dividend in a regular, taxable investment account, you have to report dividend income to the IRS each year. While the IRS generally taxes dividend income at a lower rate than earnings from a job, you're still liable to give Uncle Sam his share.

When you receive a dividend inside an IRA, you don't have to do a thing. Your IRA custodian will collect the dividend on your behalf and follow your handling instructions. With an IRA, you usually will elect one of two options. You can receive the dividend as cash. Your custodian places it in a money market sweep account inside your IRA. You can also elect to reinvest the dividend into more shares of the security that produced it.

At some juncture, you might, even if indirectly, pay taxes on the dividend income you received over the years in your IRA. When you take an IRA distribution, the IRS looks at the entire distribution for tax purposes. It considers original contributions as a whole. It lumps earnings -- dividends, interest and capital gains -- all together. When you access traditional IRA money, the IRS taxes the entire withdrawal, regardless of your age and situation. With a Roth IRA, you can escape paying taxes on earnings if you take a qualified withdrawal, which generally means a withdrawal that happens after you turn 59 1/2 and have held your Roth account for at least five years. The IRS never taxes original Roth contributions when you remove them.