As the year winds down towards winter and tax season approaches, it is important to look at the activities of your investment portfolio over the past twelve months. It is usually quite simple to list your interest income, as most brokerage statements call out the interest as a separate category. Also, most banks do a good job of sending out the 1099 forms that list interest on certificates of deposit, savings, and checking accounts. But what about those monthly and quarterly dividend transactions that are buried in the back pages of your brokerage account statements? Pay special attention to the dividends that are reinvested automatically, because many of those transactions are taxable twice. They are first taxed as dividend income, then taxed again when the shares in that account are sold. This is not applicable to IRA's because realized gains in value due to buying and selling within one account are not the point at which IRA's are taxed; they are taxed at the time of a distribution.
Many stocks and mutual funds pay monthly or quarterly dividends. If you set up your taxable brokerage accounts several years ago, you may not remember that you had specified several dividends to be reinvested into the shares that generated the dividends. This can be a good habit for building a portfolio, whereas you "set it and forget it" so that the equity in the account is increasing whether the market is high or low. Many people would rather reinvest right away in this unconscious manner, rather than parking dividends in the sweep funds for several months at a miserable interest rate. For example, if your Pimco fund generates a ten dollar dividend when the stock is worth $3.33 per share, the account is instructed automatically to purchase three shares. You are thereby maximizing the benefits of dollar cost averaging by reinvesting even the smaller dividend amounts. This is because your account is purchasing more shares per dollar when the price is low, and generating greater dividends when the stock is doing well. The only downside can be tracking these multiple small purchases at tax time.
For IRS purposes, a dividend is still taxable even when reinvested, except when it's within an IRA or a tax-exempt fund like certain government bonds. In most financial software such as Quicken, you can run a summary of all taxable dividend transactions, and this will include your reinvested dividends. Even though you did not take the dividend as a cash benefit, you still need to track the reinvested dollar amounts as taxable events at the end of each year. Also, in case the stock is sold in the future, you will need all the cost information. Selling the stock will usually require that you chronologically identify the first and last shares bought and their price at that time, compared to the price at the time of sale. A profit equates to a taxable capital gain, and a loss can equate to a tax write off. In a stock fund where a few shares were bought every month at various prices for several years, the cost information must be noted carefully.
To illustrate the importance of keeping cost records on reinvested dividends, here is an example. Perhaps you sold one hundred shares of Pimco in 2009 and want to know how much taxable profit was made. It turns out you bought these shares in small amounts-- about three at a time, over a period of 33 months during 2004 and 2005 -- through a dividend reinvestment program. As the share prices varied each time they were purchased, there are 33 different prices associated with the cost of buying of the stock, and one sale price if they were sold on one day. Hopefully your broker has kept track of all the purchase prices, and can calculate all the gains or losses based on the 33 buying transactions compared to the selling price. However, if the stock was transferred in from another account, your current broker may not have the cost history and the dates that all the purchases were made, unless you have provided the information yourself. This is where your own record keeping will have to be relied upon. Remember that a reinvested dividend is a buy, and you will need records whenever you purchase a stock, so that you know the cost at the time of purchase. Different tax rates apply to long and short term gains, so the date of purchase needs to be as accurate as possible.
You need to know the cost of the stock even when you bought one or two shares a month over a period of several years, which occurs frequently with dividend reinvestment. If you are switching brokers, the cost records still need to be kept somewhere so that the profit or loss can be calculated some day in the future, when the stock will eventually be sold. This can present a record keeping challenge, but the alternative can be a debate with the IRS, which is not a pleasant situation. The purchase price of a stock, even a reinvested dividend, must be kept until the stock is sold, which may be many years. If you are thinking of discarding your old brokerage statements, the cost information must be recorded elsewhere, such as a computerized financial software package, database, spreadsheet, or handwritten notes if all else fails.
If you bought a stock twenty years ago and lost your records on reinvested dividend share prices, it can be frustrating to recreate this cost history, but not impossible. You can research the average price of a company's stock over particular calendar years, and estimate how many shares were purchased in each year. Setting up the data in columns, each buying year would have a cost, and it would be compared to the more recent selling price. The difference in the two amounts would be the taxable gain or a loss to write off. Obviously, the less you have to guess on these figures, the less you would be exposed to an IRS audit. Actual dates and purchase prices are preferable to estimates.
In conclusion, if you want a portfolio that is very simple and requires little record keeping, reinvesting dividends may not be a good fit for you. If you tend to switch brokerage firms frequently, a redundant method of recording your frequent buy and sell activities will be needed to establish a reliable cost and value history so that your taxes can be filed correctly. However, if you want a slow and steady income builder that is resilient to changes in the market, then the frequent reinvestment of your dividends will show surprising gains over the long haul. What starts out as a few shares per month can become an attractive nest egg when you keep buying the same stock at a variety of prices, over a period of several years.