Investing in dividend stocks can create a nice stream of passive income. Instead of receiving payouts as cash, you can also use dividends to increase your holdings by reinvesting them to purchase additional shares of stock. Among other benefits, reinvesting dividends can help you avoid brokerage fees. However, even when you don’t receive dividends as cash payouts and reinvest them in additional shares, you still must pay taxes on them. For personalized tax planning assistance, work with a financial advisor.
What Is Dividend Reinvestment?
When you reinvest dividends paid by some shares and exchange-traded funds, you use the dividends to buy more shares of stock instead of receiving the dividends as cash payouts. For example, say you own 100 shares of Stock ABC and it pays a $1 quarterly dividend. You could have that $100 dividend deposited as cash into your brokerage account. Or you could choose to use the dividend to purchase $100 worth of additional shares of Stock ABC.
Reinvesting dividends can represent a savvy investment strategy. As one benefit, it taps the power of compounding. The reinvested dividends buy you additional shares and if the share price increases over time, your portfolio value grows. In addition, if Stock ABC pays an increasing dividend each year, reinvesting those rising dividends can further augment your wealth.
Many investors set up their portfolios so that dividends get automatically reinvested. This also brings into play the beneficial effects of dollar-cost averaging, which can reduce the average cost you pay for shares. As yet another benefit, purchasing shares via dividend reinvestment can also avoid brokerage commissions and fees. Not surprisingly, given these benefits, many investors employ strategies that call for reinvesting dividends.
How Reinvested Dividends Are Taxed
Investors who reinvest dividends have to keep some special considerations in mind when it comes to taxes. The IRS considers any dividends you receive as taxable income, whether you reinvest them or not. When you reinvest dividends, for tax purposes you are essentially receiving the dividend and then using it to purchase more shares. So even though the dividend doesn’t pass through your hands in cash form, it’s still considered taxable income.
However, dividends may not get taxed like regular income. For tax purposes, dividends fall into two categories – qualified and non-qualified. Each category gets taxed differently. Qualified dividends have to meet IRS holding period requirements. They get taxed at the lower long-term capital gains rates. Non-qualified dividends, also called ordinary dividends, get taxed as ordinary income. That generally means paying a bigger tax bite.
Reporting Reinvested Dividends
You must report both qualified and non-qualified reinvested dividends on your tax return. To help you accurately report these amounts, your brokerage will send you Form 1099-DIV. This tax form details your dividend income for the year and breaks it down between ordinary dividends, qualified dividends and capital gains distributions.
When the time to prepare your tax return arrives, take the dividend amounts from your 1099-DIV and enter them on your Form 1040. Report qualified reinvested dividends on line 3a. Enter amounts for non-qualified reinvested dividends on line 3b. If you have more than $1,500 in ordinary dividends, you must also complete Schedule B and attach it to your Form 1040.
Avoid Taxes with Retirement Accounts
While you can’t avoid taxes on reinvested dividends completely, a way exists to keep from having to pay taxes on reinvested dividends the year you receive them. To do this, simply hold the dividend-paying securities in a tax-deferred retirement account such as a 401(k) or IRA.
Contributions to these accounts may be tax-deductible, so your dividend reinvestments escape taxation at the time you make them. After that, your money grows tax-free over time. You do pay taxes on the reinvested dividends and earnings later when you withdraw funds in retirement. But in the meantime, you can reinvest dividends tax-free.
Bottom Line
While reinvesting dividends can help grow your portfolio, you generally still owe taxes on reinvested dividends each year. Reinvested dividends may be treated in different ways, however. Qualified dividends get taxed as capital gains, while non-qualified dividends get taxed as ordinary income. You can avoid paying taxes on reinvested dividends in the year you earn them by holding dividend stocks in a tax-deferred retirement plan.
Tips for Investing
- Consult a financial advisor if you need help determining the taxes owed on reinvested dividends. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- SmartAsset’s Investment Return and Growth Calculator helps guide your saving and investment decisions by showing you the projected growth of your investment portfolio over time.
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FAQs
While reinvesting dividends can help grow your portfolio, you generally still owe taxes on reinvested dividends each year. Reinvested dividends may be treated in different ways, however. Qualified dividends get taxed as capital gains, while non-qualified dividends get taxed as ordinary income.
Do I pay taxes on dividends if I reinvest them? ›
Dividends from stocks or funds are taxable income, whether you receive them or reinvest them. Qualified dividends are taxed at lower capital gains rates; unqualified dividends as ordinary income. Putting dividend-paying stocks in tax-advantaged accounts can help you avoid or delay the taxes due.
Is reinvesting dividends a good idea? ›
Dividend reinvestment is a great way for an investor to steadily grow wealth. Many brokers and companies enable investors to automate this process, allowing them to buy more shares (even fractional ones) with each payment and compounding their returns, which can add up over time.
How much dividend income is tax free? ›
For single filers, if your 2023 taxable income was $44,625 or less, or $89,250 or less for married couples filing jointly, then you won't owe any income tax on dividends earned.
Do I pay taxes on dividends I drip? ›
If customers choose to reinvest the money, they get cash dividends from the corporation. They will still be responsible for paying taxes on all those amounts. But if the business reinvests its dividends to buy more shares, it won't have to pay taxes until they sell them.
Does Warren Buffett reinvest his dividends? ›
Of course, you would be moving the decimal over and only buying whole shares, but this is for simplicity. Compounding Effect: This process repeats each year, with Buffett owning slightly more shares and thus earning slightly more in dividends, which he continues to reinvest.
Should I reinvest or cash out dividends? ›
Cashing out instead will preclude you from multiplying your investment. It May Take Longer To Achieve Long-Term Financial Goals: Dividend reinvestment leads to compounded growth. This makes it easier (and faster) to achieve your long-term financial goals versus keeping cash in a savings account.
How do I avoid paying taxes on stock dividends? ›
Options include owning dividend-paying stocks in a tax-advantaged retirement account or 529 plan. You can also avoid paying capital gains tax altogether on certain dividend-paying stocks if your income is low enough. A financial advisor can help you employ dividend investing in your portfolio.
Is there a downside to dividend investing? ›
Despite their storied histories, they cut their dividends. 9 In other words, dividends are not guaranteed and are subject to macroeconomic and company-specific risks. Another downside to dividend-paying stocks is that companies that pay dividends are not usually high-growth leaders.
How to reinvest profits to avoid tax? ›
7 ways to minimize investment taxes
- Practice buy-and-hold investing. ...
- Open an IRA. ...
- Contribute to a 401(k) plan. ...
- Take advantage of tax-loss harvesting. ...
- Consider asset location. ...
- Use a 1031 exchange. ...
- Take advantage of lower long-term capital gains rates.
Your “qualified” dividends may be taxed at 0% if your taxable income falls below $44,625 (if single or Married Filing Separately), $59,750 (if Head of Household), or $89,250 (if (Married Filing Jointly or qualifying widow/widower) (tax year 2023). Above those thresholds, the qualified dividend tax rate is 15%.
How much dividend is exempt from tax? ›
2. What amount of dividends are tax-free in India? For the financial year 2021-2022, you can receive up to ₹5,000 in dividend income in India without being taxed. Any dividend income you receive beyond this limit will be taxed according to the applicable tax rates and regulations.
How much tax do I pay on my dividends? ›
Outside of any tax-sheltered investments and the dividend allowance, the dividend tax rates are: 8.75% for basic rate taxpayers. 33.75% for higher rate taxpayers.
Do I pay taxes on dividends if I drip? ›
Important considerations with DRIPs
Although Schwab doesn't charge fees or commissions in DRIP, there is still a tax scenario to consider. If a DRIP is active in a non-retirement account, the dividend income is a taxable event and will be reported on your 1099-DIV as if it was received in cash.
Do I pay tax on dividends if I reinvest? ›
If the company pays out cash dividends, you will owe taxes on those payments even if you decide to reinvest the cash received. If however, the company reinvests your dividends to purchase additional shares, you will not owe taxes until you sell those shares.
How do I know if I have to pay taxes on dividends? ›
If you receive over $1,500 of taxable ordinary dividends, you must report these dividends on Schedule B (Form 1040), Interest and Ordinary Dividends. If you receive dividends in significant amounts, you may be subject to the Net Investment Income Tax (NIIT) and may have to pay estimated tax to avoid a penalty.
Do I have to pay tax on stocks if I sell and reinvest Robinhood? ›
As always, you won't have to pay tax on a stock simply because its value increased. You will, however, need to pay tax on any profits you make when you sell stock. Stocks held less than one year are subject to the short term capital gains tax rate, which is the same tax rate you pay on your ordinary income.
How to offset dividend income? ›
If your losses are greater than your gains
Up to $3,000 in net losses can be used to offset your ordinary income (including income from dividends or interest). Note that you can also "carry forward" losses to future tax years.
Do you pay taxes on reinvested dividends in a Roth IRA? ›
Therefore, you'll pay no taxes on dividends that are issued and reinvested in either a Roth IRA or traditional IRA while your money remains invested. "The great benefit of retirement accounts, IRAs and Roth IRAs, is that dividends are not taxed on an annual basis.
How do reinvested dividends affect cost basis? ›
Reinvesting dividends increases the cost basis of the holding because dividends are used to buy more shares.
