A classic strategy for growing your investments is to reinvest dividends. This way, you put your money to work immediately by purchasing additional shares of your stock, mutual fund or exchange-traded fund.
Dividends are taxed when they become payable, whether you reinvest them or not. Qualified dividends are taxed at the long-term capital gains rate.
Understanding Qualified Dividends
Many stocks pay cash dividends, usually on a quarterly basis. Most U.S. dividends and many foreign ones are classified as “qualified,” that is, qualified for favorable tax treatment. To qualify, the stock shares must be easily tradable on an American exchange, the issuing company must be incorporated in the U.S. or a U.S. possession, and, if foreign, the corporation must be subject to a comprehensive tax treaty with the U.S.
Dividends from passive foreign companies are not qualified. Neither are dividends from real estate investment trusts, employee stock options, master limited partnerships and tax-exempt companies. Dividends on shares in which you are obligated to make payments on hedged positions, such as short sales, are not qualified.
Dividend Reinvestment Tax
Qualified dividends are taxed at the long-term capital gains rate. As of 2018, this rate is 0, 15 or 20 percent, depending on your income. Ordinary dividends are taxed at your marginal tax rate for ordinary income. To benefit from the lower tax rates on qualified dividends, you must satisfy the holding period requirement.
For common stocks, you must have held the shares for at least 61 days within the 120-day period centered on the ex-dividend date. Only stocks purchased before the ex-dividend date receive the upcoming dividend payment. The holding period requirement for preferred stock is 91 days within the 180-day period centered on the ex-dividend date. In the holding period, you can’t include any days on which you had a hedge against the shares, as with short sales of the shares or call options written on the shares.
Mutual Fund Distributions
The most likely situation in which you will deal with dividend reinvestment is through mutual fund distributions, which can have several components, including:
- Dividends: Any dividend income earned by a mutual fund is passed along to shareholders at least once per year. When you receive IRS Form 1099-DIV from the mutual fund company for the tax year, you’ll be able to identify how much you received in qualified and ordinary dividends. For mutual funds, the holding period for qualified dividends is 61 days.
- Capital Gains: Nearly all mutual funds distribute all of their capital gains at least once per year. These gains, which are not dividends, are reported on Form 1099-DIV and are always considered long term, regardless of how long you held the mutual fund shares. Some mutual funds keep their long-term capital gains and pay the tax on them, as reported on IRS Form 2439. You must treat these as distributions, but you can request on IRS Form 1040 a credit for the tax paid by the mutual fund. You can instruct your mutual company on how to handle the dividend reinvestment of capital gains.
- Interest: Interest income is distributed by the mutual fund periodically, often monthly. Interest is reported as ordinary or tax-exempt dividends (not as interest). Form 1099-DIV will be sent to you early in the next year detailing your ordinary and tax-exempt income from the mutual fund for the tax year.
Mutual funds allow you to request automatic reinvestment of dividends, capital gains, and/or interest. For example, the Fidelity dividend reinvestment rules give you full control of your distributions. Reinvestments are treated as separate purchases of mutual fund shares, subject to capital gains tax when sold. If you hold the reinvested shares for a year or longer, they qualify for long-term capital gains treatment when sold.
Dividend Reinvestment Plans
Many corporations offer dividend reinvestment plans (DRIPs) to shareholders. These are handy because they allow you to purchase fractional shares of stock, something you can’t do in the stock market. Whether or not you reinvest them, they are subject to taxation as qualified or ordinary dividends and are reported on Form 1099-DIV. If you belong to a DRIP and purchase additional shares (beyond the reinvestment amount) at a discount below fair market value, you must report the discount amount as dividend interest. You use the fair market value on the dividend payment date to figure the discount amount.
Note that some brokerages offer DRIPs that allow automatic reinvestment of dividends in any of the stocks you own in your account, whether or not the dividend-issuing corporation offers a DRIP. The brokerage might simulate ownership of fractional shares until you reach a whole share amount, at which time it will buy the share for you.
Exchange-traded funds (ETFs) are baskets of securities that trade together as a unit on a stock exchange, much like ordinary stock shares. Many but not all ETFs offer a DRIP option allowing automatic reinvestment of dividends to buy additional whole shares of the ETF. Unused cash is typically maintained in a separate account.
Because ETFs trade continually throughout the day, you will not know the precise price at which the dividends will be reinvested. If you prefer to control this price, you can accept the dividend as cash and manually reinvest it at a time and price of your choosing.
If you hold your stocks, mutual funds and/or ETFs in a qualified retirement account or IRA, taxes on dividends are deferred until you withdraw money from the account. Withdrawals are taxed as ordinary income unless the account is a Roth, in which case withdrawals are tax-free as long as you follow the rules.
Advantages of Automatic Dividend Reinvestment
You can benefit in several ways by automatically reinvesting your dividends:
- Forced savings: By automatically reinvesting your dividends, you will not be tempted to take the cash and use it for other purposes. This can be a boon to those who otherwise have trouble saving money.
- Dollar-cost averaging: Every time you reinvest dividends, you buy shares at the current market price. Assuming the dividend amount remains steady, you will buy more shares when prices are low than you will when prices are high. This is known as dollar-cost averaging, and it is a classic technique for lowering the average cost of your shares.
- Compounding: The shares you buy through dividend reinvestment themselves pay dividends, creating a compounding effect as your investment grows.
- Sales fees: Some mutual fund companies and brokerages that charge a fee on the purchase of shares may offer automatic dividend reinvestment fee-free. This allows all of your dividend money to go toward the purchase of additional shares.
Disadvantages of Automatic Dividend Reinvestment
Under certain circumstances, you might not want to automatically reinvest your dividends:
- Income: Retirees and others might rely on dividend income to support their lifestyle. They would rather take the dividend as cash and use it elsewhere.
- Diversification: If you wish to diversify your portfolio holdings, you can deposit your dividends in a cash account that you use to purchase shares in other stocks or funds. This also helps prevent over-allocation to a particular stock or sector of stocks due to automatic dividend reinvestment.
- Timing: You might want to use dividends to purchase additional shares, but at a different time. For example, if you expect prices to fall, you might want to wait before reinvesting your dividends.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.