Reinvested dividends can be an easy and inexpensive way to boost your portfolio’s balance, but unless careful records are kept, the resulting impact on a stock or mutual fund’s basis may be overlooked. For tax purposes, the definition of basis is the value of an asset used to compute gain or loss when the asset is sold. In other words, it is the asset’s purchase price. Do you really know your basis in the stocks and mutual funds in your portfolio? If not, you may pay more in taxes than necessary when those investments are sold.
For income tax purposes, reinvested dividends are deemed to be constructively received by an individual. These earnings, which are reported on Form 1099-DIV, are taxed in the year received as regular dividend income, although cash was not actually distributed. Therefore, if the reinvested dividend is not added to the cost basis of the stock or mutual fund from which it was issued, you eventually could pay more in capital gains tax when the investment is sold.
For example, if you were to purchase 100 shares of stock for $1,000 in 2017, and had total dividends of $500 reinvested over the next three years, the adjusted basis on the entire investment, including the new shares purchased with the $500 of reinvested dividends, would be $1,500. If you then sell all your stock shares for $2,000 in 2020, you only need to pay tax on a gain of $500 (the difference between the sales price and the adjusted basis), rather than on $1,000 (the difference between the sales price and the original cost basis).
While mutual funds are required to keep records of each investor’s tax basis, and report it to the investor and IRS when shares are sold, it is a best practice to maintain careful records so that you can confirm the basis amount reported when the investment is sold.
Let’s switch gears and think about reinvested dividends on investments held inside a qualified retirement plan, instead of a taxable investment account held by you individually. Qualified retirement plans, such as a 401(k), are not subject to capital gains taxes. Tax is deferred on any gains inside your 401(k) account as your account grows. You will eventually be taxed on the value of your 401(k) account when you receive income in the form of a distribution. This distribution income will be taxed as ordinary income to you in the year you receive the distribution. Because retirement accounts are not taxed under the same rules as taxable investment accounts (i.e., they are not subject to capital gains tax), basis adjustments for reinvested dividends have no tax impact on your 401(k) account or future distributions.
If you have any questions about reinvested dividends, or would like to request a speaker on this topic for your organization or event, contact one of our executives below at (800) 270-9629.