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 can 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. For personalized tax planning assistance, work with a financial advisor.
What Is Dividend Reinvestment?
When you reinvest dividends paid by some shares and exchange-traded funds, 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. 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 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 non-qualified. 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. Non-qualified 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 non-qualified 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 non-qualified 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.
Avoid 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-free 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.
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 non-qualified 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 determining the taxes owed on reinvested dividends. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three 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.
Photo credit: ©iStock.com/Sean Anthony Eddy, ©iStock.com/Wengen Ling, ©iStock.com/megaflopp