Have you ever received a tax document showing you a taxable amount of dividends? You probably didn’t receive a check for those dividend amounts, but you’re still required to pay taxes on them. Why is that and how does it affect you?
Why are they taxable?
Reinvested dividends come from dividend payments for stocks and other securities that you own. You’ve elected to not receive those dividend payments, but to instead use those earnings to buy additional shares of the security. You didn’t receive the money directly, but you did benefit from having the payout. These dividends are taxable to you even though you didn’t directly receive them. Dividends received on securities you’ve owned for less than one year are treated as ordinary dividends and are taxed at your ordinary tax bracket. However, dividends received on securities you’ve owned for more than a year are treated as qualified dividends and are taxed at a lower capital gain tax rate ranging from 15-20%.
How does this affect me?
While paying taxes on the relatively small amount of dividends does seem petty, doing so creates basis in the shares you purchased with what is now considered post-tax money. This is because you paid taxes on the dividends even though they were reinvested. Basis is incredibly important when selling securities. For example, you purchase 10 shares of a stock for $100 and then sell them over a year later for $150. You are taxed at the long-term capital gain tax rate of 15% on the gain, which was $50. This case could be true if you purchased the shares with money through your advisor, or with reinvested dividends. What if you weren’t taxed on those reinvested dividends though? The entire $150 would be taxable as a capital gain.
That’s all well and good, but let’s think bigger for a moment. In one situation I experienced, one of my clients sold hundreds of shares of Exxon stock after having paid thousands of dollars in taxes on reinvested dividends over the years. By paying the tax in smaller increments over the years they averaged out their tax, rather than selling all the shares in one year as they did and having to report significantly higher gains and paying taxes at a much higher tax bracket.
Paying taxes on smaller reinvested dividends through the years is a much more attractive option than not recognizing the income in smaller intervals. There can be extreme cases where you reinvest tens of thousands of dollars in dividends each year, and if that’s the case you may need to elect to have some small portion of those dividends be sent to you by check. This is because the tax burden of $20,000 of qualified dividends taxed at the long-term capital gain tax rate of 15% would be $3,000 in tax. A difficult amount to cover when you’re not receiving the fruits of your investment directly.
If you have any questions about the potential tax liability of your financial decisions, please call Molen & Associates for your free 10-minute consultation today. You can reach us at (281) 440-6279. If this information was helpful, please subscribe to be notified when we release other blog posts in the future.