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I've read a couple of articles recently that mentioned tracking dividends as a way to save money on taxes. I have a professional handle my taxes but I know a bit about investment taxes. So, when I saw this suggestion as a tax-savings tip, I had to say to myself “huh?”
After some thought, I realized that the tip is useful under certain circumstances. But it could be misleading when placed alongside tax advice meant to be acted upon immediately.
Let's dig into this claim and understand what the advice-givers are really saying and how this tip might be beneficial.
The Reason to Track Dividend Reinvestment and Investment Cost Basis
First, let me clarify the tip.
Here's the long version of the advice: Be sure to add the cost basis of reinvested dividends to a particular investment so that when the investment is sold, the capital gain (investment proceeds less the investment cost) reflects the cost of reinvested dividends. In this way, you may be able to avoid double taxation on the dividends: once when the dividends are paid; and again when the investment is sold.
Here's a simplistic illustration of what this tip means:
- Buy 5 shares of ABC Stock for $20 each for a total of $100.
- Elect to reinvest dividends.
- ABC pays a $20 dividend, which buys another share.
- After holding ABC Stock for more than a year, sell 6 shares for $25 each and receive $150.
At first glance, I may think that my long-term capital gain on ABC is $50 ($150 for the sale less the original cost of $100). But if I kept good records, then I'd know that I should have added $20 to the cost basis because I (effectively) paid $20 to acquire more of ABC stock. So, the actual capital gain is $30 [$150 – ($100 + $20)]. If I don't remember to add the reinvested dividends to the cost basis, then I'd pay tax on these dividends in the year of the sale and in a previous year, when I received the dividend.
Yes, the first time I would have paid taxes on the dividends should have been when I received the dividends (if the investments weren't held in a tax-advantaged account). Even though they were reinvested and I didn't get cash money in my pocket, I'd still owe taxes on the dividends if the investments are held in a regular taxable account.
After paying taxes on dividends the first time (if applicable), I shouldn't have to pay taxes on them again. By remembering to add the dividends to the cost basis of my investments, I avoid paying too much in taxes. For a detailed explanation of why investment cost basis matters, see Kay Bell's article on Figuring Investment Cost Basis at Bankrate.com.
When to Apply this Advice (Hint: It's Mainly for Regular Taxable Accounts)
So, why do I take issue with this advice?
As I mentioned earlier, the tax tip is sound. It's just that it's not a slam dunk to save money on this year's taxes and, often, the tip is mixed with ideas on saving taxes this year.
In addition, tracking cost basis is unlikely to save money if investments are held in a tax-advantaged account, such as a traditional IRA, Roth IRA, HSA, or 529 Plan. Generally, for tax purposes, under current tax law, I don't need to track the cost basis of my investments held in tax-favored accounts.
The cool thing about IRAs (whether traditional or Roth) and accounts like the HSA and 529 Plan is that money grows tax-free; that is, I don't have to pay taxes on interest, dividends, or capital gains on investments when that income occurs. I may have to pay taxes when the money is withdrawn but those calculations are based on withdrawal amounts not capital gains.
Naturally, there are exceptions to this general rule. The Motley Fool covers a couple in its article on Does Cost Basis Matter in an IRA? The first situation in which cost basis may matter is when making nondeductible contributions to a traditional IRA and the other is when taking non-qualified withdrawals from the Roth IRA.
I know I can't always anticipate what investment and tax moves I'll be making. So, it makes sense to keep records of various transactions including dividend reinvestment.
One tactic I've begun to take involves opting out of automatic dividend reinvesting; instead, I take dividends as cash (if possible) and then use this money to buy another investment. This approach may make it easier for me to track cost basis (though harder to see the performance of an investment as overall return should include both stock price increases and dividends).
The bottom line: Tracking dividends may help me save money but not always.
I'm not a tax professional. Consult your tax professional for questions and concerns regarding taxes.
How do you track your cost basis and reinvested dividends?