Dividend reinvestment plans offer the convenience of automatically reinvesting any cash dividends paid by the company in new shares without you having to touch the money. However, just because you don't receive the money in your bank account first doesn't mean you don't have to include the dividends in your taxable income for the year.
Dividends are Taxable
If you reinvest your dividends, even through an automatic DRIP, the INternal Revenue Service still considers you to have received the income, and therefore it is taxable. For example, if you would have received a $50 cash dividend, but instead you received two extra shares of the company, you must include $50 of dividend income on your income tax return. In addition, if the company that runs the DRIP pays fees without passing them on to you, you must also pay taxes on that amount. For example, if company X runs a DRIP for its investors and pays a $5 fee to reinvest the dividends but does not charge you that $5, you must include that extra $5 in your income.
At the end of the year, you should receive a Form 1099-DIV that shows you how much you received in dividends during the year, including dividends that you reinvested in the same company. In box 1, you should see all of the dividends you received during the year. In box 2 appears your qualified dividends, which are dividends that qualify for the lower long-term capital gains tax rates.
Ordinary dividends are taxed at your regular income tax rate. Qualified dividends, on the other hand, are taxed at the lower long-term capital gain rates. Qualified dividends must be paid by a domestic corporation or a qualified foreign corporation. Foreign corporations are qualified if they are either incorporated in a U.S. possession or if they are eligible for benefits under a qualifying tax treaty. In addition, you must have held the stock for at least 61 days during the 121-day period that begins 60 days before the ex-dividend date.
When you reinvest your dividends, your basis, or the amount you paid, for your shares of stock as a whole increases because you are putting additional money into the company. For example, assume that you paid $2,000 to acquire 100 shares stock and that when it pays its dividend, you receive an additional two shares worth $50 total. Now, you own 102 shares of stock and your cost basis increases to $2,050. Therefore, if you were to sell all of your shares for $2,600, you would report $550 of gains rather than the $600 you would have reported without the basis increase.
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