Why Your IRA Needs Dividend Stocks

In your quest to save for retirement, tax-favored retirement accounts are valuable tools to help you set aside and grow your money. But eventually, all good things must come an end, and regardless of if you want to, you need to start taking money out of your traditional IRAs and 401(k) accounts. If you don't, the IRS will gladly sock you with a penalty you simply can't afford to pay. And with the recent volatility we've seen in the stock market, you need to make sure your retirement investments will produce enough income to give you the cash that the IRS makes you take out.

Dealing with the RMD
Millions of workers have enjoyed the benefits of retirement saving through IRAs and 401(k)s. When you set money aside in one of these tax-favored retirement accounts, you generally get to fund it with pre-tax money -- meaning that you either get a deduction on your tax return (in the case of IRAs) or have that money excluded from your taxable income on your paystub (for 401(k) accounts). That's a huge boost that often gives you thousands in tax savings year in and year out.

Even better, once your money is inside your retirement account, you get to defer paying taxes on the income it generates throughout your lifetime. The only time you'll pay tax on a traditional IRA or 401(k) is when you take money out of your account. That's why most people try to leave money inside their retirement accounts as long as they can.

When lawmakers created IRAs and employer retirement plans, they knew that taxpayers wouldn't want to pay taxes any sooner than they had to. So they included provisions in the laws that govern retirement accounts to force people to take their money out under certain conditions, regardless of whether they actually needed the money. These required minimum distributions apply to two groups of people: accountholders who will be age 70 1/2 or older at the end of 2011, or those who inherited IRAs and weren't eligible to do a spousal rollover into their own accounts.

What's the deal?
Once you know that you have to take an RMD, the hard part is calculating it. Each year, you have to take out a fraction of your total traditional retirement account assets. That fraction is determined by your life expectancy and will change every year, but for those in their 70s, the required withdrawal is about 4% to 5% of your retirement portfolio. By the time you're in your 90s, that figure can approach or exceed 10%.

And worst of all, if you don't take your RMD, the IRS hits you with a 50% penalty on the amount you should have taken. So you simply have to find a way to come up with the cash.

Financing those distributions is where dividend stocks come in. If you want to take your RMDs without selling stock, then you need stocks that will pay you enough income to cover the RMD.

Fortunately, those who've just started having to take RMDs have plenty of good choices to get them into the 4% to 5% yield range. Utility stock Duke Energy (NYS: DUK) and telecom giant AT&T (NYS: T) are obvious choices with highly attractive yields. But at current yields, you have the luxury of building a truly diversified dividend-producing portfolio. For instance, recycling giant Waste Management (NYS: WM) offers not only a high current yield but also strong dividend growth, which can be even more important. Drugmaker Eli Lilly (NYS: LLY) and cigarette maven Philip Morris International (NYS: PM) also add some sector breadth while still providing the yield you need.

Once your RMDs get into the double-digit percentage realm, though, your choices get more limited. Rural telco Frontier Communications (NYS: FTR) and mortgage REIT Annaly Capital (NYS: NLY) make the grade as far as yield is concerned, but they may not fit well with the conservative investing styles that most older retirees prefer for their portfolios. Nevertheless, they remain an option for those who are dead-set against selling stocks and invading their principal.

Don't wait
If you have to take an RMD, you have until the end of the year to do it. But with the end of the year often getting hectic, think about doing it now rather than procrastinating. With half your distribution on the line, you can't afford to mess this up.

For more smart dividend stocks that can get you the RMD money you need, check out the Fool's free special report on dividend stocks. You'll find 13 high-paying stocks that will help you get the job done.

At the time thisarticle was published Fool contributor Dan Caplinger fondly remembers his mom every year when he takes his modest RMD. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Philip Morris International, Annaly Capital, and Waste Management. Motley Fool newsletter services have recommended buying shares of Philip Morris International, AT&T, and Waste Management, as well as writing a covered strangle position in Waste Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never penalizes you.

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