Reinvesting dividends can be a sound investment strategy, as you are compounding your investment interest. To reinvest a dividend, you use the dividend to purchase additional shares of the stock or mutual fund issuing the dividend. Since dividends are based on the amount of shares you own, reinvesting your dividends increases your future dividends, all other things being equal, since you now own a greater amount of shares. However, if you don't properly account for your dividend reinvestment you can end up paying more tax than you should.
Record the amount of your dividend. If you have possession of your stock or mutual fund, the issuing company will send you a record of the dividend amount. If you hold your investments at a financial services firm, such as a bank, you should see the dividend on your monthly statement or in your online account activity.
Add the dividend amount to your initial cost basis. Your initial cost basis is the amount you originally paid for the mutual fund or stock, including all costs such as commissions and fees.
Divide your total combined cost by your total number of shares after reinvestment. This will give you an average cost per share. For example, if you originally paid $1,000 for 100 mutual fund shares, your average cost is $10 per share. If over the course of a year you receive another 10 shares as a result of $122 in dividends, your total cost is now $1,122. Divide this by your 110 total shares and you'll find your average cost per share is now $10.20.
Report your costs and sales to the IRS. If you sell any capital asset, such as a stock or mutual fund, you must report it to the IRS when you file your taxes. The amount of gain or loss you have on your shares will determine what your tax liability will be. If you sell your entire lot of shares, you can simply report your total cost basis, total sales proceeds and number of shares sold. If you only sell part of your holdings, you will have to identify which shares you are using for tax purposes. If you are selling reinvested mutual shares, you can typically use an average per-share cost basis. You can choose to identify specific shares to sell, as you must for stock sales. If you don't make a selection, the IRS will choose "first-in, first-out" or "FIFO" identification for you, in which the first shares you bought are considered your first shares sold.
- To maximize your tax benefits, a tax professional may be needed if you are selling only a portion of your reinvested shares.
- Starting in 2011, rules were implemented requiring financial services firms to better track and report cost basis information for customers.
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