Dividend reinvestment can be a good way of adding to your shares of a company's stock. That's especially true when a company's reinvestment plan lets you buy shares with no fees so all of your dividend money goes to buying shares. It's important to keep careful records of your dividend purchases. Otherwise, you might end up paying a lot more income tax than you actually owe when you eventually sell the shares.
Taxes on Stock Income
Stocks make money in two ways. Some stocks pay dividends, which are taxed in the year you get them as ordinary income. Dividend income over $400 is reported using Schedule B. Otherwise you simply add it in on your form 1040 tax return. When you sell the shares you will have either a capital gain or loss. Gains may be taxed at a different rate, while losses are tax deductible. Capital gains and losses are reported to the Internal Revenue Service in the year of the sale using Schedule D.
As far as the IRS is concerned, the payment of dividends on shares of stock and the reinvestment of those dividends are two separate events. When dividends are paid, they are taxable income. When you use the money to buy more stock in the company, it's an investment of money no different than if you pulled the money out of your checking account to make the purchase. The fact that the reinvestment is handled as a single transaction in a dividend reinvestment plan makes no difference.
When you sell shares of stock, you deduct your cost basis from the proceeds of the sale. Cost basis is the total amount of money invested, including broker's commissions and other transaction costs. The difference between cost basis and sale proceeds is your taxable gain or deductible loss. Any reinvested dividends are after-tax dollars. If you don't add them to your cost basis, you will end up overstating the capital gain. Suppose you invest $1,000 in a stock, add $200 in reinvested dividends, and sell the whole thing for $2,000. You must add the reinvested dividends to the cost basis or you will report and pay taxes on a $1,000 taxable gain instead of the correct amount of $800.
Capital Gains Taxes
When you sell a stock investment, gains on shares you've owned for more than one year are taxed as a long-term capital gain at a maximum rate of 15 percent. Shares held for one year or less are short term, and gains are taxed at ordinary income tax rates. This means you need to report any gain on shares bought with reinvested dividends less than one year before the sale as short-term gains, even if most of your investment is a long-term capital investment.