Every time you hit a new year—or even a new quarter—it makes sense to take a look at your Roth IRA account balance. What you need to check is whether that balance is growing, how much it’s growing and where the growth has come from.
If your account is not growing through after-tax investments that you’ve made—or by growth in the investments you hold—there may be other places to look. Account growth can also come from interest (if you are utilizing a Roth IRA Certificate of Deposit), stock dividends (if you are brave enough to invest in individual stocks), and mutual fund dividends and capital gains.
Let’s take a closer look at how these three categories can impact your Roth.
Roth IRA Interest Income
One of the ways you may see an increase in your account is through being paid interest on an investment. The most common investment that kicks off interest to you is a certificate of deposit. These CDs pay interest to you inside a Roth IRA just as they would if you held them outside of a Roth. You will usually have interest paid out when the certificate of deposit matures.
Many Roth IRA providers will allow you to roll over your interest into a new CD at a new rate. Either way, the interest will cause growth in your account.
Roth IRA Stock Dividends
Investing in individual stocks is extremely risky. If you put your entire portfolio into ten stocks and one stock tanks, it could take 10% of your nest egg with it. Yet, some people still use individual stocks as part of their portfolio strategy. They might target high dividend payers such utility stocks in hopes of earning a higher return than with a certificate of deposit. Dividends are normally paid out quarterly.
Roth IRA Mutual Fund Dividends and Capital Gains Distributions
A third potential source of account growth are dividends or capital gains distributions from your mutual funds. Dividends are treated just like individual stock dividends with the exception that most mutual funds pay out dividends only once per year (usually in December).
Capital gains distributions are a different beast. Let’s say you invest in Mutual Fund A on November 1st. That same mutual fund picks up shares of Stock B on February 1st. Stock B’s price has skyrocketed and the mutual fund managers are looking to cash out. They sell the shares the following December 1st and incur a capital gain on the difference of the price between when they bought and when they sold the shares.
That capital gain can be offset by losses on other stocks, but if there isn’t enough to offset them, the capital gains hit is pushed out to the mutual fund investors. Capital gains distributions are similar to dividends, but most investors look to avoid them due to tax concerns.
Tax-Free Retirement with a Roth IRA
Your account balance going up is always a good thing. No one will complain about a larger nest egg. And the beauty of the Roth IRA is that all account growth—whether from interest, dividends or distributions—is 100 percent tax free. You get the interest, dividends and even capital gains without having to pay additional tax on them, as you would in a regular investment account.
They would also grow tax-free in a Traditional IRA. However, when you retire, you’ll have to pay taxes on all the funds you withdraw. And the requirement to take minimum distributions from age 70½ on means there is no way to duck taking income from your Traditional IRA, even if you don’t need it.
then you would be much happier than if you had to pay tax. That’s the beauty of the Roth IRA. All Roth IRA investments you make are made with after tax dollars. You’ve already paid income tax on the money you contribute.
If it’s not, that’s of course a reason to look at whether you should make any changes in your portfolio.
Traditional IRA investors typically look for low turnover (and thus low capital gains) mutual funds. Roth IRA investors do not have this worry. A tax free retirement — something we can all agree on is worth investing in.