Usually, when you buy stocks, you aim to increase your passive income. Therefore, you will do everything possible to ensure that your money remains in your bank account and not in the Federal Reserve. However, since evading tax will land you in jail, it is up to you to arrange your affairs such that the amount you remit to the government terms of taxes does not beat the purpose of investing. Once you receive your dividends and are wondering if it is prudent to reinvest them or cash them out to reduce your tax liability, let’s help you make a decision.
Taxation of reinvested dividends
Unfortunately, regardless of whether you choose to reinvest the dividends, cash them out, or be paid in terms of stock, you will still pay tax. Dividend reinvestment as the process of using cash dividends to buy additional stock in the same company. While you may not have received the dividends in cash, the IRS treats it as though you did and still taxes you, hence you should indicate reinvested dividends as dividend income. If your company does not give you cash and instead offers you dividends in the form of additional stock through a dividend reinvestment plan, you will not pay tax immediately, but once you sell them, you are expected to pay. However, you should note this only happens if you are not given the choice of taking the dividends in cash or reinvesting them yourself.
Dividend reinvestment tax is dependent on the type of dividend; dividends are classified as either qualified or ordinary. Ordinary dividends are taxed as ordinary income and include those paid on deposits with financial institutions, tax-exempt organizations, foreign corporations, and capital gains distribution, among others. On the other hand, qualified dividends are those received from a US company, a company in US possession, a foreign company’s stock which can be traded on a US stock market, and international company in a country eligible for benefits under tax treaty of the United States. Qualified dividends are not taxed on people between the 10% and 12% income bracket, but upwards, the tax rate increases depending on the income tax bracket. The maximum rate currently on qualified dividends is 20%.
Why you should opt for dividend reinvestment plans (DRIPs)
No brokerage fees
Instead of taking the cash and then looking for a broker to reinvest your dividends in the company again, a DRIP enables you to do away with brokerage fees. Such fees are expenses that will reduce your income; thus, with the company giving you additional shares without any cost involved, you are at an advantage.
Motley Fool explains that you should choose to reinvest your dividends through the DRIP to take advantage of accruing long-term returns. As the article explains, more dividends offer you a higher purchasing power of your next reinvestment, and of course, the more the shares, the more the dividends you will receive.
Investors are always looking for the best time to invest their money, which can be costly in the long run when they make a miscalculated investment. With a DRIP, your company affords you the peace of mind of knowing that your money will buy the same amount of stock regularly. Even if the shares are at times undervalued, the occasional overvaluation will even out the effects of the fluctuating prices.
Besides allowing you to pay your taxes when you are ready to sell the accumulated shares, DRIP reduces the amount you will have spent buying through other channels. Apart from eliminating brokerage fees, the company extends additional shares to you at a much lower price.
Lack of diversification
As much as the lack of transaction fees and the discounted prices are enticing enough to consider a DRIP, you should be careful not to have too much stock in one company. Having shares in a company whose future looks promising will encourage you to invest, but the stock market is unpredictable; hence, it pays to diversify your income sources. AFAM Capital provides a solution to this problem; by letting your dividends accumulate in your brokerage account, you can use them later to buy stocks in other companies.
Lock yourself out of better deals
Investing is all about looking for the best-performing stocks to maximize your returns. By investing and reinvesting in only one company’s shares, you lose out on buying other shares to increase your yield. Therefore as AFAM Capital still emphasizes, diversification is the best way to go. Consequently, you can choose to reinvest dividends in a particular company and allow the rest of your shares in other firms to buy better performing shares.
You can avoid dividend reinvestment tax
Benjamin Franklin said death and taxes are the only sure things in life, but Simply Safe Dividends enlighten us there are ways we can avoid the dividend reinvestment tax. You can contribute to tax-deferred accounts such as the IRA and 401(k)s, but there is a limit depending on age and account type. For instance, with the IRA, you can only make a maximum contribution of $5,500 if you are below 50, and once you are 50 and older, the cap is $6,500. For the 401(k), 403(b), and 457, those below 50 contribute a maximum of $18,500; if 50 and above, the amount is capped at $24,500.
However, you should that tax-deferred accounts only defer taxation, meaning that you will be taxed once you withdraw any amount in retirement. Contrastingly, if you hold tax-free accounts, you will not pay any tax in funds withdrawn because you will have already paid tax before setting aside the money in the account. advises that if the money you are saving is for paying college tuition, then stashing it in a 529 savings plan will still work.