I recently took a deep dive into the pros and cons of dividend reinvestment. Readers of this article asked me questions about other dividend-related topics. Here are some of the most common questions I receive:
What should I know about reinvesting dividends and wash sales?
Reinvesting dividends means purchasing additional shares, which could complicate sales or tax losses in taxable accounts. IRS wash sale rules prohibit claiming a tax loss after the sale if you purchased the same or “substantially identical” security before or 30 days after the sale. You can wait at least 30 days after a dividend before selling, and be sure to sell at least 30 days before the next dividend, but to reduce headaches, it’s best not to reinvest dividends into holdings that you plan to sell soon.
If I reinvest the dividends, will I end up with fractional shares that are difficult to sell?
Reinvesting dividends usually means buying a small amount of dividends and adding them to your existing stock/fund position. You may end up with fractional shares, meaning you only own part of the shares. Most prime brokerage firms allow you to sell odd lots, but you typically need to sell odd lots on a market order, and it may take an extra day to clear the odd lot.
How are dividends taxed?
For stocks and stock funds, the tax rate depends on whether the dividend is a qualified dividend or a nonqualified dividend (also called an ordinary dividend). Dividends qualify if you meet the 60-day holding requirement within the 121-day window around the ex-dividend date; the assets are taxed at the capital gains rate – either 0% or 15% for most people. Others are taxed as ordinary income. Dividends that do not meet these requirements are disqualified and taxed as ordinary income.
Bond or bond fund payments are considered interest income and are generally taxed as ordinary income. Income from Treasury bonds is exempt from state and local taxes, and income from municipal bonds is generally exempt from federal, state, and local taxes, depending on the location of the issuer.
Are reinvested dividends taxable?
As I mentioned in another article, dividends held in a taxable account are taxable whether they are cash or reinvested. If you reinvest dividends, you’ll need to add each dividend to your cost basis of holding. You may end up with many separate tax jurisdictions with different cost basis levels. When you sell stock, you need to match each sale to a specific tax batch.
Are dividend-paying stocks better?
Money is fungible – it doesn’t matter whether you receive income or capital appreciation. The value of a company should not depend on whether it pays dividends. However, behavioral finance researchers have found that many investors view dividends as more stable and predictable than capital gains. Tax issues are another important consideration.