If My Dividends Are Reinvested, Are They Taxed?

Many mistakenly believe that dividends are not taxed if reinvested into additional shares instead of paid as cash. While reinvesting dividends can grow a portfolio, it does not exempt the income from tax. Understanding these tax implications is important for financial planning and compliance.

Taxation of Reinvested Dividends

Reinvested dividends are taxable in the year they are paid, even if the investor never directly receives the cash. This is due to the tax principle of “constructive receipt,” which dictates that income is taxable when it is made available to a taxpayer without restriction, regardless of whether they physically possess it. The IRS considers a dividend income when it is credited to an account or made available, even if used to purchase more shares.

A dividend is a distribution of property by a corporation to its shareholders from its earnings. The IRS treats these distributions as income, like cash dividends, because the investor controls the funds. Thus, whether received as cash or reinvested through a dividend reinvestment plan (DRIP), the amount is taxable income in the year it is paid.

Qualified Versus Ordinary Dividends

The tax rate applied to dividends depends on their classification as either qualified or ordinary. Qualified dividends are taxed at lower long-term capital gains rates, typically 0% to 20% depending on income. To be qualified, a dividend must be paid by a U.S. or qualifying foreign corporation, and the stock held for a specific period. For common stock, the holding period requires ownership for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.

Ordinary dividends are taxed at regular income tax rates, which can range from 10% to 37%. Dividends not meeting qualified criteria, such as those from real estate investment trusts (REITs), money market accounts, or certain foreign corporations, are typically ordinary. This distinction significantly impacts tax liability, as ordinary dividend rates can be substantially higher than qualified rates.

Adjusting Your Cost Basis

Cost basis refers to the original price paid for an investment, including fees. When dividends are reinvested, they purchase additional shares, directly increasing the investment’s cost basis. This adjustment reduces the taxable capital gain when shares are sold.

For example, if shares were bought for $1,000 and $300 in dividends reinvested, the adjusted cost basis becomes $1,300. When sold, the taxable gain is calculated based on this higher adjusted cost basis, not the initial purchase price. This prevents double taxation: once on the dividend, and again as a capital gain when shares are sold. Maintaining accurate records of reinvested dividends is important for calculating cost basis and minimizing future tax.

Reporting Reinvested Dividends

Brokerage firms report dividend income to investors and the IRS on Form 1099-DIV. This form details distributions received. Box 1a of Form 1099-DIV shows total ordinary dividends, while Box 1b reports qualified dividends.

Investors use the information from Form 1099-DIV to complete their tax returns. If total ordinary dividends or taxable interest exceed $1,500, they must be reported on Schedule B (Form 1040). Otherwise, dividend income can be reported directly on Form 1040. Reinvested dividends are included on Form 1099-DIV and must be reported on the tax return like cash dividends.

Reinvested Dividends in Tax-Advantaged Accounts

Dividends, whether cash or reinvested, receive different tax treatment in tax-advantaged retirement accounts. In Traditional IRAs or 401(k)s, dividends and other earnings grow tax-deferred. Taxes are not typically due on dividends in the year earned or reinvested, but upon withdrawal during retirement.

Roth IRAs offer a more favorable tax structure. Dividends and other earnings within a Roth IRA grow completely tax-free. Qualified withdrawals from a Roth IRA in retirement are also tax-free, provided certain conditions are met. This contrasts with taxable brokerage accounts, where dividends are subject to annual taxation regardless of reinvestment.