How Are Reinvested Dividends Taxed?

While the dividend reinvestment process has been simplified and streamlined over the years, investors new to the process might be interested in finding out how exactly are reinvested dividends taxed.

As most investors know, all dividends are not created equal in the eyes of the taxman. The Internal Revenue Service (IRS) applies separate tax tables to different types of dividends. However, before diving deeper into dividend types and tax rates, let’s discuss the overall dividend reinvestment process.

How Are Reinvested Dividends Taxed? — Dividend Reinvestment

The IRS defines dividend reinvestment as “dividends used to buy more stock” of the company in which an investor already has a stock ownership. The easiest way to reinvest dividends is through an automatic dividend reinvestment plan (DRIP) if the company has already established such a plan. A DRIP allows investors to use their dividend distributions to purchase additional shares of stock in the company through an outside agent. These additional shares replace the cash dividend distributions. Along with public companies that afford investors the opportunity to reinvest dividends to buy additional shares of stock, some mutual funds also allow their stakeholders to use the fund’s distributions to acquire additional fund units instead of receiving cash payouts.

One of the most important things that investors must understand is that dividend reinvestment is different from stock dividend distributions. While the end result is identical — investors end up with additional shares of the company’s stock — the overall process and especially the tax treatment, are vastly different. The IRS treats stock dividend distributions as stock splits. That means that the investors are not responsible for any tax liability in the year in which the stock dividend is distributed. Like with any other stock that the investors might own, the tax liability occurs only on any gains after the investor sells the stock. At that time, any profit is subject to taxation at capital gains rates.

How Are Reinvested Dividends Taxed? — Reporting Taxable Income

If investors use cash dividend distributions to purchase more shares, the IRS considers the cash dividend distributions as taxable income and investors must report it as such. Even additional shares purchased through a DRIP are subject to the same reporting requirement. Investors must report the fair market value of the additional stock on the dividend payment date as dividend income.

Additionally, investors must also report any service charges subtracted from their cash dividends before the dividends are used to buy the additional stock as dividend income. However, in some instances, investors might be able to deduct the service charge. Investors can find the complete details on which charges and fees can be deducted and under which circumstances in Publication 17, Chapter 27 — “Other Itemized Deductions”.

Some dividend reinvestment plans allow shareholders to invest extra cash beyond the current dividend distribution to purchase additional shares at a price that is generally less than the fair market value. In this case, investors must report the difference between the additional cash invested and the fair market value of the stock purchased as dividend income for that calendar year. To calculate this difference — i.e. the taxable dividend income — investors must use the stock’s fair market value on the dividend payment date.

How Are Reinvested Dividends Taxed? — Dividend Types

Once investors properly report the reinvested dividends as taxable income, the taxation process proceeds in the same manner as all other dividend distributions. The main determinant of the tax rate is the type of dividend distribution. qualified dividends enjoy the benefit of taxation at at a rate that is equal to the rate at which capital gains are taxed. The benefit of this lower taxation can add significant gains to total portfolio wealth after compounding over a long-term horizon.

While stock dividends have no immediate tax liability, cash dividends incur the standard tax liability at ordinary income tax rates for the year in which the dividends are paid. However, a slight extension applies to dividends that are distributed by mutual funds, exchange-traded funds (ETFs), unit investment trusts (UIT) or other regulated investment companies (RICs). These types of investments can distribute dividends until the end of January of the following year and those distributions can still be reported as taxable income in the previous year with an assumed December 31 pay date. However, in order to include these distributions as prior-year income, these dividends must have been declared in the previous year and must have a Date of Record in the fourth quarter of the previous year — October, November or December.

While Qualified Dividends enjoy taxation at the same rates as capital gains, Ordinary or Non-Qualified dividend are subject to taxation at ordinary income tax rates, which are generally higher than capital gains rates. Investors usually can identify the type of dividend from the location where the dividend amount appears on the 1099-DIV tax form. However, there are some specific classification requirements and a few exceptions that investors must understand.

How Are Reinvested Dividends Taxed? — Qualified Dividends

To qualify for the lower capital gains tax rate, dividend distributions must meet a whole set of specific criteria. The criteria fall into three general categories.

1. A U.S. corporation or a qualified foreign corporation must be the legal entity distributing the dividends. The IRS has a specific set of requirements that define what a Qualified Foreign Corporation.

2. The dividend distribution must not be of the type listed by the IRS as “Dividends that are not qualified dividends.”

3. The investor must meet specific stock holding requirements for dividend distributions to maintain the qualified dividend designation.

How Are Reinvested Dividends Taxed? — Ordinary Dividends

1. In most cases, the ordinary dividend amount paid on common and preferred shares will appear in box 1a of the 1099-DIV.

2. However, some dividend distributions will always be classified as ordinary dividends even if they meet all necessary requirements for qualified dividends listed in the previous section above. For example, dividend distributions from real estate investment trusts (REITs), tax-exempt companies or master limited partnerships (MLPs) are always treated and taxed as ordinary dividends. Additionally, one-time dividends, special dividends and dividends on employee stock options always fall into the ordinary dividend classification.

3. Because they are technically interest distributions, dividends from money market accounts are always reported and taxed as ordinary income. Furthermore, all dividend distributions from sources related to hedging — such as short sales, call options, put options, etc. — cannot have a “qualified” status

How Are Reinvested Dividends Taxed? – Tax Rates

So far, we have discussed various aspects that help to answer questions regarding “how are reinvested dividends taxed?” While far from a complete answer, the general implications should be clear by now. The only missing piece of the taxation of reinvested dividends puzzle are the exact tax rates. The current tax rates applicable to all dividend distributions in the 2018 tax year have been defined by the Tax Cuts and Jobs Act (TCJA) that was passed by Congress on December 22, 2017.

Ordinary Dividends are subject to taxation at rates outlined in the table below.

Qualified Dividends enjoy taxation at the lower, capital gains, rates which are outlined in the second table here.

Taxation and tax rates are not the first selection criterion that investors will consider when seeking dividend-paying equities. Investors generally evaluate securities based on other characteristics, such as dividend yield, history of dividend payments, annual dividend hikes, the stock’s share price history or moving average, etc. However, tax implications can be important in distinguishing between securities with similar financial and dividend distribution characteristics. In these cases, picking the security that offers the advantage of lower taxation can translate into substantial long-term gains.

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