Dividend Reinvestment Tax: How It Works

Dividend reinvestment plans, or DRIPs, allow investors to systematically increase their ownership in a company. Instead of receiving cash, these programs use dividends to automatically purchase additional shares, allowing an investment to compound over time. While this is a hands-off way to grow a portfolio, it has tax considerations that are often misunderstood. Even though the shareholder never receives cash, the IRS considers the value of reinvested dividends to be taxable income for the year in which they are paid.

The Immediate Tax on Reinvested Dividends

The tax on a reinvested dividend is based on the principle of constructive receipt. The IRS treats the transaction as two separate events: the company pays a cash dividend, and the shareholder immediately uses that cash to buy more shares. Therefore, the value of the dividend is considered income for that tax year and must be reported, creating a tax liability without the investor receiving cash.

The tax rate applied to this income depends on whether the dividends are “qualified” or “non-qualified.” Qualified dividends are subject to the more favorable long-term capital gains tax rates of 0%, 15%, or 20%, based on the investor’s taxable income. For the 2025 tax year, the 0% rate applies to taxable income up to $48,350 for single filers, $96,700 for married couples filing jointly, and $64,750 for heads of household. The 15% and 20% rates apply to higher-income earners.

To be qualified, dividends must be paid by a U.S. corporation or a qualifying foreign corporation, and the investor must hold the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. Non-qualified dividends do not meet these criteria and are taxed at the investor’s regular ordinary income tax rates, which can be as high as 37%. For example, $100 in qualified dividends could result in a $15 tax, while the same amount in non-qualified dividends could result in a $24 tax for someone in the 24% bracket.

Reporting Dividend Income on Your Tax Return

Each year, investors who receive more than $10 in dividend income from a single source, including reinvested amounts, will receive a Form 1099-DIV, “Dividends and Distributions,” from their brokerage. This form is sent by January 31 of the year following the tax year in which the dividends were paid and is used to report this income to the IRS.

The Form 1099-DIV provides a breakdown of the distributions received. Box 1a, “Total ordinary dividends,” shows the full amount of taxable dividends paid. Box 1b, “Qualified dividends,” specifies the portion of the amount in Box 1a that meets the criteria for the lower capital gains tax rates.

When preparing a tax return, the amounts from these boxes are transferred to the appropriate lines. The total from Box 1a is reported as ordinary dividend income, and the amount from Box 1b is used to calculate the tax using the preferential qualified dividend rates. If an investor’s total ordinary dividend income is over $1,500, they must complete and attach Schedule B (Form 1040) to their tax return.

Establishing Cost Basis for Reinvested Shares

While reinvested dividends are taxed as income, they also establish the “cost basis” of the newly acquired shares. Cost basis is the original value of an asset for tax purposes. When you eventually sell shares, the cost basis is subtracted from the sale proceeds to determine the capital gain or loss, which prevents being taxed twice on the same money.

The amount of the reinvested dividend becomes the cost basis for the shares purchased with it. For instance, if a $100 dividend is reinvested to purchase two new shares, the cost basis for those two shares is $100, or $50 per share. This $100 is added to the total cost basis of the investor’s entire holding in that stock.

Record-keeping is important for investors using DRIPs. Each time a dividend is reinvested, it creates a new “tax lot”—a group of shares purchased at a specific date and price. Investors should keep brokerage records detailing the date of each reinvestment, the dividend amount, and the number of shares purchased to calculate capital gains or losses accurately when they sell.

Calculating Capital Gains When Selling Shares

To calculate the capital gain or loss on a sale, subtract the cost basis of the shares being sold from the net proceeds of the sale. The tax treatment of the gain or loss depends on the holding period of the specific shares sold.

If the shares were held for one year or less, the profit is a short-term capital gain and is taxed at the investor’s ordinary income tax rate. If the shares were held for more than one year, the profit is a long-term capital gain and is taxed at the lower rates of 0%, 15%, or 20%. The holding period for each reinvested lot begins the day after the dividend reinvestment date.

Investors can choose which tax lots to sell. They might use the “First-In, First-Out” (FIFO) method, where the oldest shares are considered sold first. Alternatively, they can use specific share identification, allowing them to select shares with a higher cost basis to minimize taxable gains or to harvest losses.

Dividend Reinvestment Within Tax-Advantaged Accounts

The tax rules for dividend reinvestment are different when investments are held within a tax-advantaged retirement account, such as a Traditional IRA, Roth IRA, or 401(k). Inside these accounts, the immediate taxation of dividends does not apply. Dividends can be paid and reinvested to purchase additional shares without creating a taxable event in the current year, allowing the investment to grow on a tax-deferred or tax-free basis.

Within a Traditional IRA or 401(k), taxes on dividends and capital gains are deferred until the investor takes distributions in retirement, at which point withdrawals are taxed as ordinary income. For a Roth IRA, contributions are made with after-tax dollars, so reinvested dividends and all other growth can be withdrawn completely tax-free in retirement, provided certain conditions are met.

Because there is no annual taxation on dividends or capital gains within these accounts, tracking the cost basis of reinvested shares is unnecessary. The tax consequences are determined by the rules governing withdrawals from the specific type of retirement account. This makes dividend reinvestment a simpler process inside a qualified retirement plan compared to a standard taxable brokerage account.