Filing a tax return can be a laborious process that grows more complex as you make investments and earn income from different sources. Uncle Sam imposes taxes on many types of income besides wages and salaries, including the dividend payments you receive for holding stock or mutual fund investments. Taxes on dividends apply even if you reinvest the dividends, so you must declare reinvested dividends on your tax return.
Reinvested Dividend Basics
A dividend is a payment that a corporation can choose to make to shareholders as a means of attracting investment; it's essentially a portion of the company's earnings. When you receive a dividend from a stock or mutual fund investment, you may have the option of automatically reinvesting the dividends. When you reinvest, you use a dividend payment to purchase more shares instead of accepting a cash payment. Reinvestment is a common way to increase investment growth when you don't need an extra cash income stream.
Taxes on Dividends
Dividend income is subject to special tax rules that apply regardless of whether you take cash payments or reinvest. The IRS says that you should receive Form 1099-DIV from each company that pays you at least $10 in dividends annually and that you have to report the income on your tax return. If you participate in a dividend reinvestment plan where you can buy shares of stock at a price that is lower than its market value, you have to treat the fair market value of the additional stock as dividend income.
If you save money in a retirement account such as a 401(k) plan or an individual retirement account, you can avoid paying taxes on reinvested dividends. Money you contribute to a 401(k) or IRA grows on a tax-defered basis, meaning capital gains and dividends earned in your account are not subject to taxation at the time that you earn them. You don't pay taxes on your investments until you withdraw funds during retirement, at which time you pay normal income taxes on the funds you withdraw.
Most companies that offer dividends make cash payments, but some corporations offer dividends in the form of additional shares of stock. Stock dividends are similar to reinvestment in that you gain additional shares of stock over time, but they are treated differently for tax purposes. According to the IRS, you generally do not have to pay taxes on stock dividends you receive as long as you don't have the option to receive cash or property instead of stock.