Reinvested dividends are taxable, just as if you received them in cash. However, certain dividends are subject to lower tax rates than others, and there are ways to reduce or eliminate these taxes.
Dividends are one of the biggest perks of stock investing. In addition to the increase in value your stocks are likely to experience over time, dividends provide a source of regular income as companies pass profits along to their shareholders.
Some people choose to receive their dividends as income, which they can use to pay for monthly expenses or invest in other assets. However, many people choose to reinvest those dividends in their brokerage accounts so they can grow over time. If you’re considering reinvesting your dividends, it’s important to understand the tax implications.
Are reinvested dividends taxable?
Any income you receive from your investments — unless it’s in a tax-advantaged retirement account — is subject to taxes. It may seem that since you aren’t actually receiving your dividends, you shouldn’t have to pay taxes on them.
Unfortunately, your dividends will be taxable regardless of whether you receive them as income into your bank account or reinvest them in your brokerage account. If you want to start investing in your account, consider the brokerages below.
How dividend reinvestment works
Dividends are distributions that companies make to their shareholders, usually as a way of passing along some of their profits. When you, as a shareholder, receive those dividends, you can choose to reinvest them in your brokerage account rather than receiving them as cash in your bank account.
There are two primary ways you can reinvest your dividends.
- Direct dividend reinvestment. First, you can set up direct dividend reinvestment in your brokerage account. Most brokers have a setting in your online account that you can activate to reinvest your dividends automatically.
- Dividend reinvestment plans. The other way you can reinvest your dividends is through a dividend reinvestment plan, or DRIP, which most companies offer directly. You don’t necessarily need an online brokerage account to set up automatic dividend reinvestment, but you do need to make sure the company offers a DRIP.
When you reinvest your dividends, you buy additional shares of stock with that money. As a result, the value of your portfolio grows and will continue to grow as the value of the stock grows. Additionally, because you own more shares, you’ll end up earning more dividends in the future, which you can then receive as cash or reinvest again in your account.
How dividends are taxed
As we mentioned, dividends are subject to taxes, regardless of whether you receive them in cash or reinvest them in your brokerage account or dividend reinvestment plan. The amount you’ll pay in taxes depends on the type of dividends they are.
Taxes on qualified dividends
Qualified dividends are subject to more favorable tax rates than ordinary income tax rates. However, they are subject to long-term capital gains tax rates, which are either 0%, 15%, or 20%, depending on your annual income.
To be considered “qualified,” dividends must have been paid by a U.S. corporation or a qualified foreign corporation. You must also have held the stock for more than 60 days during the past 121-day period, starting 60 days before the ex-dividend date. Finally, the dividends must not be specifically included in the list of dividends that aren’t qualified dividends.
Taxes on ordinary dividends
Dividends that aren’t considered qualified dividends are considered ordinary dividends. Ordinary income tax rates range from 10% to 37%, and you’ll usually end up paying considerably more in taxes than you would for qualified dividends.
Ordinary dividends are those that don’t meet the requirements of a qualified dividend, including those on the list of dividends excluded from being qualified. Included on that list are capital gains distributions, dividends on deposits with banks and credit unions, dividends from a tax-exempt corporation, and more.
How to reduce taxes on reinvested dividends
Unfortunately, reinvested dividends are subject to the same tax treatment as those dividends you receive in cash. The good news is there are ways to reduce the amount of taxes you’ll have to pay.
The simplest way to reduce, and even eliminate, taxes on reinvested dividends is to receive them in tax-advantaged retirement accounts like 401(k) plans and individual retirement accounts (IRAs). To do that, you’ll have to own the stocks directly in the retirement account where you want to receive the dividends.
Why does this work? Income and capital gains earned in retirement accounts aren’t subject to taxes as long as the money remains in the account. In the case of pre-tax accounts like a 401(k) or traditional IRA, you’ll only pay income taxes when you withdraw funds. And in the case of a Roth IRA or Roth 401(k), you’ll pay taxes before you invest in those funds.
Another way to reduce the taxes on your dividends is to earn qualified dividends instead of ordinary ones. As we mentioned, dividends that are qualified are eligible for a more favorable tax rate than ordinary dividends. If you know you’ll be receiving both qualified and ordinary dividends, and want some of your holdings in a taxable brokerage account, consider structuring your asset allocation. This way, you receive your qualified dividends in your taxable brokerage account and your ordinary dividends in your tax-advantaged account.
Should you reinvest your dividends or take the cash?
When you receive a dividend payment from a company you’ve invested in, you probably find yourself wondering whether to reinvest it or simply take the cash. There are pros and cons to both options.
Compare the features of cashing and reinvesting your dividends before you make a decision.
- Extra money. The obvious perk of receiving your dividends in cash is that you have a bit of extra money in the bank. And depending on how steady your dividend income is, you can use it to help pay for your monthly expenses or to save for financial goals.
- Cover dividend taxes. Another benefit is that when tax time rolls around, you can use a portion of the money you received in dividends to cover the tax burden.
- Purchase additional stock. First, when you reinvest your dividends, those funds are used to purchase additional shares of stock. While you may not see the immediate benefit you would when you receive the dividends in cash, there’s a considerable long-term benefit. As the value of those shares grows, so will your portfolio.
- Increase your dividend income. Not only will you increase the value of your portfolio over the long term by reinvesting your dividends, but ultimately you’ll increase your dividend income. Because you’ll own more shares, you’ll be eligible for more dividends when the company decides to issue them.
Are you taxed twice on reinvested dividends?
Dividends are technically taxed twice, though you, as the taxpayer, don’t directly pay those taxes twice. First, dividends are taxed as corporate income when the company earns the money. They’re taxed a second time when the shareholder pays taxes after receiving their dividends.
How can I avoid paying tax on dividends?
The only way to avoid taxes on dividends entirely is to earn them in a tax-advantaged retirement account, such as a 401(k) plan or an individual retirement account.
What is the tax rate on reinvested dividends?
The tax rate on reinvested dividends depends on whether they are qualified or ordinary dividends. Qualified dividends are taxed at the long-term capital gains tax rate, while ordinary dividends are taxed at your ordinary income tax rate.
- Generally speaking, dividends are subject to taxes regardless of whether you reinvest them in your brokerage account or receive cash dividends.
- Dividends can be considered either qualified or ordinary dividends, each of which has a different tax treatment.
- You can reduce taxes on your reinvested dividends by receiving them in a tax-advantaged retirement account, or by receiving qualified instead of ordinary dividends.
View Article Sources
- Topic No. 409 Capital Gains and Losses — IRS
- Publication 550: Investment Income and Expenses — IRS
- How To Invest In The Stock Market: 8 Basic Concepts — SuperMoney
- Beginner’s Guide to Investing — SuperMoney
- How to Avoid Capital Gains Tax on Stocks — SuperMoney
- What Are Exempt-Interest Dividends? Definition and Tax Rules — SuperMoney
- What is Return of Capital (ROC)? — SuperMoney
- What is Par Value in Stocks and Bonds? — SuperMoney
- What is Backup Withholding? — SuperMoney
- Best Brokerage Apps | May 2022 — SuperMoney