I have been getting double whacked on taxes on reinvested dividends and didn’t realize it. Fortunately it hasn’t been much money, since I don’t typically buy stocks that pay dividends. However, that’s going to change going forward. I need to build some significant dividend streams, so that I can spend more time on the golf course.
Source: Sound Mind Investing
Q: Should you reinvesting fund dividends in a taxable account?
A: For most people, choosing not to reinvest dividends in a taxable account is probably a good move. Each distribution buys you more shares, and in taxable accounts you have to account for each purchase individually on your taxes. Later, when you sell a fund where distributions have been reinvested, you’ll have to wrestle with all those individual transactions in adjusting your basis. And if you don’t adjust your basis for prior distributions, you’ll end up paying tax on the distributions twice — once in the year each was received, and again when the fund is sold.
To avoid the whole issue, we suggest having distributions deposited in your money market fund instead. If you regularly add new money to your taxable account anyway, it’s very simple to lump any cash from fund distributions in with your normal purchases. If not, you’ll need to occasionally make a separate purchase to reinvest the accumulated cash. But that’s not bad—those purchases can be made strategically in underweighted risk categories, a sort of periodic mini-rebalancing. Either way, occasionally having a little cash sitting idle is the price of avoiding this tax hassle.
Understand that this advice only applies to taxable accounts — any IRA or other tax-advantaged account should be set up to have your dividends reinvested because you don’t have to account for those distributions in preparing your annual taxes.