Here’s a question I’ve asked clients countless times over the years, when they’ve sold a mutual fund; “when did you buy the fund, and how much did you pay for it”? The title of this article refers to reinvested dividends, which comes up most often with mutual funds, but for those who own stocks in dividend reinvestment plans, this discussion also applies.
I decided to write this article for two reasons. The first reason is that I’ve had plenty of clients who had no idea that reinvested dividends increase the cost basis of their investment. The second reason is that when I tell these clients about this, they either don’t want to go back and gather the information on the reinvested dividends, or are unable to get that information. That’s a shame, because they wind up paying more tax than they need to, due to reporting a higher gain or smaller loss than they should.
The best way to explain the effect reinvested dividends has on a sale is by example. Suppose I invested $10,000 in the JayCPA Aggressive Growth Fund on November 4, 2009. Based on the share price of $100 that day, the $10,000 bought 100 shares of the fund. On December 22, 2009, the fund paid a dividend of $10 per share. For the 100 shares I own, the dividend received was $1,000, and because I chose to have my dividends reinvested (rather than paid out in cash), the $1,000 bought an additional 10 shares. I now have 110 shares that cost me $11,000. On April 16th (my first day of post-tax-season freedom), I go out and buy a new motorcycle, and need some cash to help pay for it, so I sell my 110 shares of the JayCPA Aggressive Growth Fund. The share price that day is $200, so I net out 110 X $200, or $22,000 (do I know how to invest, or what?!).
It’s nice that I made such a good profit on the sale of that fund, but, of course, I need to think about taxes. If I disregard the reinvested dividends, and just pick up my original purchase price, I’m going to reflect a gain of $12,000 ($22,000 sales proceeds less $10,000). This is incorrect because I sold 110 shares but I’m only picking up the cost of 100 shares. Reflecting it correctly, my gain would $11,000, not $12,000 ($22,000 sales proceeds less $11,000 cost basis). So by not reflecting the value of the reinvested dividends, I’ve overstated my gain by $1,000, and since I held that fund less than a year, I have to treat that gain as ordinary income, subject to my top marginal tax rate. If I’m in the top (35%) federal tax bracket, I’ve just overpaid my tax by $350 ($1,000 x 35%). That’s a costly “penalty” for sloppy record keeping.
The best way to avoid overpaying tax on sales of mutual funds or stocks in dividend reinvestment plans is to keep track of your reinvestments. Why pay more tax when you can pay less?! Contact me if you have any questions, and please feel free to leave a comment.