One reason to buy stock is to receive a cash dividend, a payment that some companies make to their investors each year or quarter. Investors can keep dividends to spend as they please or reinvest them to buy more shares or additional stock in a mutual fund. Reinvested dividends are not eligible for tax write-offs, but they can still be a potential source of tax savings.
Companies can issue two different types of dividends: stock dividends and cash dividends. Stock dividends provide investors with additional shares of stock automatically. Cash dividends, on the other hand, are investment income that stockholders can elect to either receive as checks or reinvest to buy more stock at its market price. Reinvested dividends incur the same income tax as cash dividends that investors receive and keep for themselves.
Reducing Capital Gains
One way that reinvesting dividends can save you money on taxes is by reducing your capital gains when you sell stock in the future. Capital gains are the income you must claim when you sell stock for more than it cost to initially buy. As long as your stock's value is higher than your cost basis (the price you paid for the stock) when you reinvest dividends, the reinvestment increases your cost basis. This allows you to subtract a larger cost from the money you earn, reducing your total gain and the amount of tax you owe on it.
Reinvesting dividends can also provide a tax savings indirectly if you write off your investment expenses associated with the reinvestment process. Deductible investment expenses reduce your taxable income. They include fees you pay to financial advisers and stock brokers, money you spend on tax-management software and the cost of reinvesting your dividends themselves if your broker, mutual fund manager or the company that issues the dividend charges a fee. You can only write off the amount you spend managing your investments, not the full amount of dividends you reinvest.
Reinvesting dividends can also affect your taxes in other ways. Even though reinvesting dividends may add to your cost basis when you sell, it will also likely increase the amount of money you receive when you sell your investment. For example, if your dividends buy you five extra shares of stock that are worth $10 each, you can add $50 to your cost basis, whenever you sell. However, if those same shares are worth $15 when you sell, you'll still pay taxes on the $25 the stock has gained since you purchased it with reinvested dividends. Even if your stock loses value, you'll still earn more for selling it than you would if you hadn't reinvested your dividends, not accounting for the cash you'd receive by keeping the dividend for yourself. This minimizes the overall tax impact or reinvested dividends.
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