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Investing in dividend stocks can create a nice stream of passive income. Instead of receiving payouts as cash, you can also use dividends to increase your holdings by reinvesting them to purchase additional shares of stock. Among other benefits, reinvesting dividends may help you avoid brokerage fees. However, even when you don’t receive dividends as cash payouts and reinvest them in additional shares, you still must pay taxes on them.
A financial advisor may help you evaluate whether dividend reinvestment fits your broader investment and tax strategy, and identify ways to manage the impact of taxes on your portfolio.
What Is Dividend Reinvestment?
When you reinvest dividends paid by some shares and exchange-traded funds (ETFs), you use the dividends to buy more shares of stock instead of receiving the dividends as cash payouts. For example, say you own 100 shares of Stock ABC and it pays a $1 quarterly dividend per share. You could have that $100 dividend deposited as cash into your brokerage account. Or you could choose to use the dividend to purchase $100 worth of additional shares or fractional shares of Stock ABC.
Reinvesting dividends can represent a savvy investment strategy. As one benefit, it taps the power of compounding. The reinvested dividends buy you additional shares and if the share price increases over time, your portfolio value grows. In addition, if Stock ABC pays an increasing dividend each year, reinvesting those rising dividends can further augment your wealth.
Many investors set up their portfolios so that dividends get automatically reinvested. This also brings into play the beneficial effects of dollar-cost averaging, which can reduce the average cost you pay for shares. As yet another benefit, purchasing shares via dividend reinvestment can also avoid brokerage commissions and fees. Not surprisingly, given these benefits, many investors employ strategies that call for reinvesting dividends.
How Reinvested Dividends Are Taxed
Investors who reinvest dividends have to keep some special considerations in mind when it comes to taxes. The IRS considers any dividends you receive as taxable income, whether you reinvest them or not. When you reinvest dividends, for tax purposes you are essentially receiving the dividend and then using it to purchase more shares. So even though the dividend doesn’t pass through your hands in cash form, it’s still considered taxable income.
However, dividends may not get taxed like regular income. For tax purposes, dividends fall into two categories: qualified and nonqualified. Each category gets taxed differently. Qualified dividends have to meet IRS holding period requirements. They get taxed at the lower long-term capital gains rates. Nonqualified dividends, also called ordinary dividends, get taxed as ordinary income. That generally means paying a bigger tax bite.
Reporting Reinvested Dividends
You must report both qualified and nonqualified reinvested dividends on your tax return. To help you accurately report these amounts, your brokerage will send you Form 1099-DIV. This tax form details your dividend income for the year and breaks it down between ordinary dividends, qualified dividends and capital gains distributions.
When the time to prepare your tax return arrives, take the dividend amounts from your 1099-DIV and enter them on your Form 1040. Report qualified reinvested dividends on line 3a. Enter amounts for nonqualified reinvested dividends on line 3b. If you have more than $1,500 in ordinary dividends, you must also complete Schedule B and attach it to your Form 1040.
Defer Taxes with Retirement Accounts
While you can’t avoid taxes on reinvested dividends completely, a way exists to keep from having to pay taxes on reinvested dividends the year you receive them. To do this, simply hold the dividend-paying securities in a tax-deferred retirement account such as a 401(k) or IRA.
Contributions to these accounts may be tax-deductible, so your dividend reinvestments escape taxation at the time you make them. After that, your money grows tax-deferred over time. You do pay taxes on the reinvested dividends and earnings later when you withdraw funds in retirement. But in the meantime, you can reinvest dividends tax-free.
Curious how 401(k) or IRA contributions affect your taxes? Run the numbers with our income tax calculator.
How Reinvested Dividends Affect Your Cost Basis
Reinvesting dividends can boost long-term growth, but it also creates an important tax record that investors should not overlook. Each time a dividend is reinvested, the distribution is generally treated as taxable income for that year, even though the money never reaches your bank account. Because you have already paid tax on that income, the reinvested amount becomes part of your investment’s cost basis.
That adjustment matters when you eventually sell. Capital gains tax is based on the difference between your sale proceeds and your adjusted basis. Every reinvested dividend increases the amount you have invested in the position, which can reduce the gain that is ultimately subject to tax.
For example, suppose you invest $1,000 in a stock or mutual fund and reinvest $400 of dividends over several years. Your total investment in the position is now $1,400. If you later sell the holding, using only the original $1,000 purchase price would overstate your gain and potentially increase your tax bill.
The effect becomes more significant over long holding periods. Investors who have automatically reinvested dividends for 10, 20 or 30 years may have dozens or even hundreds of separate purchases embedded in a single position. Those additional investments can substantially increase basis and lower the taxable gain when shares are sold.
Most brokerage firms now track basis information for many securities and include adjusted figures on year-end tax forms. However, gaps can still arise, particularly with older holdings, transferred accounts or positions acquired before modern reporting requirements took effect. In those situations, investors may need to rely on historical statements, dividend records and transaction confirmations to establish an accurate basis.
Share accounting methods can also affect the outcome. Depending on the investment and the election on file with the brokerage, gains may be calculated using average cost, first-in-first-out or specific share identification. The method used can influence how much gain is recognized and how much tax is ultimately owed.
Before selling a long-held dividend-paying investment, it is worth confirming that all reinvested dividends have been properly incorporated into the basis calculation. Small adjustments made over many years can add up to a meaningful difference in the taxable gain reported when the investment is sold.
Bottom Line
While reinvesting dividends can help grow your portfolio, you generally still owe taxes on reinvested dividends each year. Reinvested dividends may be treated in different ways, however. Qualified dividends get taxed as capital gains, while ordinary or nonqualified dividends get taxed as ordinary income. You can avoid paying taxes on reinvested dividends in the year you earn them by holding dividend stocks in a tax-deferred retirement plan.
Tips for Investing
- Consult a financial advisor if you need help assessing how different portfolio moves, including reinvesting dividends, will impact your tax liability. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- SmartAsset’s investment return and growth calculator helps guide your saving and investment decisions by showing you the projected growth of your investment portfolio over time.
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