When you sell stock, you will owe capital gains tax if the shares were sold for a profit. The amount of gain is the value received from the sold shares minus your cost basis in the shares. To reduce the amount of taxes due, you want to make sure the cost basis is calculated correctly including any reinvested dividends.
Dividend Reinvestment Plans
Many companies offer investors dividend reinvestment plans. With one of the plans, an investor's shares are held by the plan sponsor and any dividends earned from the shares are reinvested into more shares of the stock. Over time, the number of shares in the investor's reinvestment plan account will grow as will the dollar value of the account. Dividend reinvestment allows an investor to compound the dividends earned from stock shares.
Taxes on Dividends
With the dividend reinvestment plan, the investor will receive a IRS Form 1099 DIV each year with the amount of dividends earned on the shares and reinvested. Although the dividends have been reinvested, they are included on the investor's annual tax return. Taxes will be paid each year on the dividends earned in the previous year. This means the money represented by the shares paid for with reinvested dividends has been taxed.
Dividends Increase Basis
Reinvested dividends do increase the investor's basis in the total number of shares owned in a dividend reinvestment plan account. As an example, an investor purchased $5,000 worth of shares in a dividend reinvestment plan. Over the period of time the plan was in effect, the investor earn $1,000 in dividends which were reinvested. If all of the shares in the plan were sold, the investors basis would be the original $5,000 investment plus the $1,000 of reinvestment for a total of $6,000.
It is not uncommon for an investor to own shares in a dividend reinvestment plan for many years. It is important to keep records of all investment amounts and the values of the dividends which have been reinvested. If reinvested dividends are not accounted for when the shares are sold out of a dividend reinvestment plan, the investor could end up paying taxes twice on the dividends; once when they were reinvested and again as capital gains tax if they are not included in the basis of the sold stock.