Reinvesting the dividends paid by a mutual fund or a stock in a dividend reinvestment plan -- DRIP -- is a great way to get compounded investment growth. Dividends you earn -- including reinvested dividends -- are taxed in the year you earn them. Capital gains on the shares purchased with reinvested dividends are paid only when the shares are sold. Keeping accurate records is the key to not paying too much in taxes on your reinvested dividends.
Tax on Reinvested Dividends
The dividends you earn over the course of a year are taxable income for that year, whether or not you reinvest them. You will receive a Form 1099-DIV stating the amount of dividends you earned. You must include the dividends on your income tax return. Dividends are taxed as dividend income and not as capital gains. The only reinvested dividends which would not be taxed are those from a municipal bond mutual fund.
Capital Gains When You Sell
Capital gains from an investment are recognized and taxed only when the investment is sold. When you reinvest dividends, those dividends are used to buy more shares of stock. Whether or not you need to pay capital gains taxes comes into play only when you sell shares -- whether you purchased those shares yourself, or whether they were purchased from from the reinvestment of dividends. A capital gain occurs if you sell the shares from reinvested dividends at a higher price than the cost of the shares.
Cost Basis for Gains
A taxable capital gain is the difference between your selling price for shares and the price you paid for the shares. Your purchase price for shares is called your cost basis. Reinvested dividends are taxed when earned and then add to your cost basis in the investment for capital gains purposes. For example, you invested $1,000 in a mutual fund and have earned and reinvested $50 in dividends. As a result your cost basis is $1,050. If you sell all of your fund shares for $1,110, your taxable capital gain would be $60, not the $110 difference between what you originally paid for the fund shares and your selling value.
Individual Shares and Recordkeeping
Each time you have dividends reinvested, those dividends buy shares and the shares have a cost basis of the price paid for the shares. To accurately calculate capital gains taxes, you must have a record of every share purchased at what price including the shares purchased with reinvested dividends. The tax rules then allow you to use a first-in-first-out -- FIFO -- designation or an average cost basis method to determine your capital gain on any shares you sell. If you make a partial sale of your investment position and do not use the average cost basis, you must be able to list the purchase price and date of of the shares sold. A collection of your year-end statements will provide the information you need to correctly report capital gains.