Those Taxing Dividend Issues
To Reinvest or Not To Reinvest ...
Gordon Gecko may be out of prison, but it’s still the case that “money never sleeps,” as the subtitle of the sequel to the classic film “Wall Street” proclaims. Individuals and clubs using automatic investing programs such as dividend reinvestment plans (DRIPs) or direct stock plans (DSPs) often like the wide-awake nature of these systems because they help keep their money always at work through the purchase of new shares with all dividends paid.
Keeping your money at work is at the core of one of BetterInvesting’s four principles of successful stock investing: Reinvest all earnings. The intent of this guideline is to allow you to take advantage of the law of compound returns and maximize the eventual gains you can earn in your stock portfolio by using your profits to make new investments.
Whenever you sell a stock or receive a dividend, use that cash to make new investments. Don’t splurge on a new pair of shoes or electronics gear! Over the course of many years, the largest part of your returns will likely come from the reinvested earnings in your investment accounts.
BetterInvesting’s admonition is often interpreted, however, as a directive to use dividend reinvestment programs, either in your brokerage account or as part of a direct stock purchase plan. Although using a DRP or DSP can fulfill the recommendation to reinvest all earnings (as well as to invest regularly), it’s not the only way.
Many investment clubs and investors choose to receive all dividends in cash and then simply add those funds to the pool of money used to make the next purchase in their portfolio. This strategy is perfectly aligned with BetterInvesting’s principles and in fact may be a better approach than automatic dividend reinvestment for a number of reasons, particularly for investment clubs.
How the IRS Views Dividends
Before we get into the pros and cons of dividend reinvestment, you should know a few things about dividends and taxes. Stock dividends are usually taxable when not held in a qualifying retirement account.
Dividends from certain common stocks qualify for a lower tax rate, what are known as “qualifying dividends,” depending on the holding period of the shares relative to the ex-dividend date. For this reason, it’s critical to include the correct ex-dividend date when entering these transactions in your club’s books. If you don’t, the investment club software may not be able to accurately calculate your qualifying and nonqualifying dividends and will be at odds with what your brokerage firm reports to the Internal Revenue Service at year-end.
Even when dividends are reinvested, they’re still taxable just as if they’d been remitted in cash. There’s no difference between a dividend distribution that’s paid in cash and one that’s reinvested in the purchase of additional shares.
Cons of Dividend Reinvestment
Although there are negatives to automatic dividend reinvestment, you should know that I’m a huge proponent of low-cost direct stock investing programs (I even wrote a book on the subject for the Idiot’s Guide series published by Alpha Books). But there are some circumstances, particularly in investment clubs, when dividend reinvestment might not be the best choice.
One reason you might want to avoid dividend reinvestment in your brokerage account is that beginning in 2012, financial institutions are required to report Form 1099-B to the IRS with the cost basis of any common stock sold after Jan. 1, 2011. In 2013, this reporting will be extended to company- or bank-sponsored dividend reinvestment plans and mutual fund companies.
I’m dubious about the ability of brokerage firms to meet this obligation with a very high rate of accuracy; adding four dividend reinvestment transactions a year, with each tax lot having its own cost basis, is only going to add to the complexity and increase the likelihood of errors that you might have to sort out with your brokerage.
Another reason to stay away from dividend reinvestment is due to the bookkeeping headaches that could result from the increased number of transactions related to DRIPs. Although myICLUB and Club Accounting 3 handle these reinvestment transactions with ease, each reinvestment is considered an additional purchase of stock and has its own tax basis that must be tracked over time.
Down the road, when your club might sell all or part of its holdings or transfer shares to a withdrawing partner or conduct your club’s annual audit, you’ll have many transactions that can complicate matters significantly. If you purchase a stock, then reinvest its quarterly dividends for five years, at the end of that period you’ll have 21 separate tax lots to manage when selling!
Mess up just one digit in the number of shares or total received in just one of those transactions when entering them in your books, and you could have a chore ahead of you if the numbers don’t match your brokerage reports. Even if you’re a proficient club treasurer, consider who might someday replace you in the position. Will those individuals be able to handle the additional workload with the same ease? Finally, some investors dislike automatic dividend reinvesting because they prefer to make their own decisions about every investment made in their portfolios.
Pros of Dividend Reinvestment
Proponents of dividend reinvestment plans like to point out that a big advantage to DRIP investing is that it employs dollar-cost averaging to improve results.
With dollar-cost averaging, investing the same amount regularly enables an investor to buy fewer shares of a security when its price is high and more shares when the price is low, thus reducing the security’s average cost per share over time.
Although this is true, investment clubs and other investors who invest regularly in the stock market are already using a similar approach. The difference is that instead of investing the same amount in the same security regularly, you’re investing the same amount in those securities that appear to be most undervalued, whether they’re already in your portfolio or not.
Another advantage of DRIP investing is that it’s completely automatic. You don’t need to do anything to keep your money working for you.
In an investment club, however, you and your fellow members are making decisions as often as each month to make new investments, reinvest in existing holdings or raise capital for the next purchase.
The automatic nature, therefore, simply isn’t as important in the context of running an investment club. Even so, the cumulative effect of reinvesting dividends over the decades can still add up to quite a nice bundle of cash and returns.
Advice for Club Treasurers
Before I wrap up this month’s column, here’s one tip for club treasurers. Occasionally, some brokerages or companies offering DRIPs reinvest the dividends the day after they’re paid to shareholders.
In that case, you shouldn’t use the dividend reinvestment transaction in Club Accounting 3 or myICLUB.com. Instead, enter the dividend on the first day, depositing the cash to the Suspense account.
On the next day, record the purchase of shares made with the dividend, funding the purchase from the Suspense account. Doing this will keep your and your brokerage’s records in accord.
Douglas is ICLUBcentral's product manager, helping develop the company's programs including Toolkit 6, myICLUB.com, and the Investor Advisory Service. He is also the author of several investing books, including The Pocket Idiot's Guide to Direct Stock Investing, The Complete Idiot's Guide to Online Investing, The Armchair Millionaire, and Investment Clubs for Dummies.