A 401(k) plan allows you to set aside a portion of your wages before tax in a tax-advantaged retirement savings account. The earnings -- such as dividends -- on those savings also grow tax-deferred until you are ready to make withdrawals in retirement. If you own stock from your employer in your 401(k) you get to elect what happens with the dividends paid on that stock.
401(k) Investment Options
The typical 401(k) plan allows participants to allocate their contributions to a selected group of mutual funds. The choices include stock funds, bond funds, international funds and possibly some specialty mutual funds. For publicly traded companies, company stock is often included as one of the 401(k) investment choices. The company stock option allows an employee to invest a portion of her retirement savings in the stock of the company she works for.
Mutual Fund Dividends
If you invest in mutual funds in your 401(k) account, any dividends paid by the funds you own are reinvested into more shares of the same fund. When you set up your 401(k) allocation, you do not have a choice of what happens with fund dividends; all fund distributions are reinvested. You do not pay any taxes on the dividends earned, since your 401(k) account grows tax-deferred as long as the money remains in the account.
Company Stock Dividends
The option to purchase company stock in your 401(k) plan can also classified as a qualified employee stock ownership plan, or ESOP. Under the ESOP rules you must be given the option to either reinvest the dividends paid on company stock into more shares of the stock or have dividends paid out directly to you. The choice of where the 401(k) company stock dividends go is an election on your 401(k) investment choices form.
If you choose to have the dividends on company stock in your 401(k) paid out to you, the dividends are taxable income and must be included on your tax return. There are no additional tax penalties if you are younger than age 59 1/2 and elect to receive company stock dividends in cash. Your company's 401(k) plan should allow you to change your stock dividend election once a year.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.