Tax Treatment of Reinvested Dividends
Dividends are a form of income, and as such, they must be reported in your income tax return. They are taxable the same way all earned income is taxable even if they are reinvested in stock and the money does not reach the taxpayer directly.
Some companies offer dividend programs where investors may opt to have all dividend payments automatically reinvested back into the company to purchase additional shares. This process allows the investor to obtain more stock without having to put more money into the investment. In this instance there are no dividend checks issued. These are referred to as Dividend Reinvestment Plans (DRIPs).
DRIPs are occasionally run through the company itself. They can also be administered by a transfer agent or broker. If the transaction involves an agent, then he or she will typically purchase additional shares on your behalf.
Even though a taxpayer does not receive a cash distribution or have “control” over it, the IRS still considers reinvested dividends a form of income. This means that you are taxed on your reinvested dividends just as if the company wrote you a check for the dividend payment.
You should receive a 1009-DIV from the company or your broker for use in preparing your tax return. Even if you have not received this form, you are still responsible for reporting the income to the IRS.
It is important to note that dividends are often taxed when the company declares the dividend, not necessarily when it is received. That means that if the company declares a dividend in November, but you do not receive it until January, you will still include the income on your prior year return.
Deferring Taxes with Stock Dividends
Companies occasionally forgo the traditional cash dividend and provide additional company shares of a comparable value. This is often referred to as a stock dividend.
A stock dividend is different from a reinvested dividend because, with a reinvested dividend, you could get cash for the dividend, but you are choosing to reinvest it. With a stock dividend, you are paid with stocks directly. This is a subtle distinction that means you may not be taxed in the same way.
Taxpayers can then defer taxes on this, only paying when they sell the stock. This deferral method can be beneficial for many taxpayers. Keep in mind, for this to be true, the company must only offer dividends in the form of stock, with no cash option.
Q&A: What are my tax liabilities on investment income?
A taxpayer's tax liability on investment income can be based on the type of investment that it is and how long it was held. For example, in the case of income from the sale of an investment like a stock or mutual fund, your tax liability will be based on if it was held for at least a year before selling. Long-term gains (over one year) are taxed anywhere between 0% and 20% depending on your income level, while short-term gains (less than a year) are taxed at your usual income tax rate.
If the investment is held in a traditional IRA, in most cases, taxes are not paid on the contributions, rather the IRS taxes the withdrawals. A Roth IRA works opposite to this as the contributions are made with after tax dollars and therefore withdrawals are usually not taxed at all.
For investments that distribute income to owners, the tax liability varies based on if it is paid in the form of a qualified dividend or interest. Qualified dividends are taxed at the long-term capital gains tax rate. Interest income on the other hand is taxed as ordinary income at your regular tax rate.