When you buy stocks, you may receive periodic cash payments called dividends that corporations elect to distribute to shareholders as a means of attracting retaining investment. Cash dividends are taxable, but they are subject to special tax rules, so tax rates may differ from your normal income tax rate. Reinvested dividends are subject to the same tax rules that apply to dividends you actually receive, so they are taxable unless you hold them in a tax-advantaged account.
Dividend Reinvestment Basics
Corporations and mutual fund companies often have "dividend reinvestment plans" that let you automatically use dividends to purchase additional shares instead of receiving cash payments. Dividend reinvestment can increase the value of a portfolio even if the prices of stock remain stagnant. Reinvestment does not, however, let you avoid paying taxes on dividends; you must report reinvested dividends as dividend income. If your dividend reinvestment plan lets you purchase shares at a price below market value, you must report the fair market value of the additional stock as dividend income.
Ordinary Vs. Qualified Dividends
The tax rate on reinvested dividends and other cash dividends depends on whether the dividend is considered "ordinary" or "qualified." Qualified dividends are those paid by U.S. corporations and certain qualified foreign companies where you meet a minimum holding period requirement. According to the Internal Revenue Service, you must hold a stock for 60 days during the 121-day period that begins 60 days before the ex-dividend date to meet the requirement. The ex-dividend date is the first day new shareholders aren't entitled to receive the next dividend payment. Qualified dividends are taxed at a maximum rate of 15 percent. Ordinary dividends are those that don’t count as qualified and are taxed at your normal income tax rate.
Some corporations pay dividends in the form of additional shares of stock instead of cash. While stock dividends and dividend reinvestment both result in gaining additional shares of stock, they are treated differently for tax purposes. Stock dividends are generally not taxable unless you have the option to receive cash instead of stock or the dividends are paid on preferred stock.
It is possible to avoid taxes on reinvested dividends if you hold investments in a retirement account that offers tax-deferred growth like a 401(k) plan or an individual retirement arrangement. Tax deferment means you don't pay taxes on capital gains, interest or dividends. Instead, you typically pay income taxes when you withdraw your money. If you invest in a Roth IRA, you generally don't pay taxes on investment gains or withdrawals.