Dividend reinvestment plans, or DRIPs, are the easiest way for hands-off investors to execute this simple strategy because they allow your dividends to be paid in partial shares each quarter (or month).
How are Dividend Reinvestments Taxed?
Unfortunately, Uncle Sam doesn't care what you do with your dividends; the IRS will treat both cash dividends and DRIP plans the same for tax purposes. As a result, there are two important factors that determine your tax bill from reinvesting dividends.
The tax rate for reinvested dividends (and qualified dividends) is based on your adjusted gross income and under current tax law looks like this.
Fortunately, no matter your income qualified dividend tax rates are still far below the top marginal tax rates that most people would pay if dividend reinvestments were taxed as ordinary income.
Specifically, dividends paid by REITs and BDCs are taxed as non-qualified dividends at your marginal tax rate. Meanwhile, most MLP distributions are taxed as a return of capital, meaning that MLP distributions lower your cost basis over time and thus defer taxes until you sell your units. MLPs have important pros and cons when it comes to tax planning.
Non-qualified dividends are taxed as ordinary income, and thus at your top marginal tax rate. For most Americans that equates to a 10%, 12%, or 22% dividend tax rate, which is also the rate at which reinvested dividends are taxed.
For the top earners dividend tax rates can be as high as 37%. Depending on your income level, taxes can significantly lower your long-term total returns over time for REIT and BDC investments.
These types of stocks are primarily owned for their income and typically have relatively slow dividend growth. Fortunately, there is a way to minimize your dividend and dividend reinvestment taxes.
How to Minimize Dividend Reinvestment Taxes
Here are the maximum annual contributions you can make to such programs based on age:
What if you don't need your retirement account funds to pay your bills? Well, the IRS has thought of that, and starting at age 70.5 the government requires you to take out a required minimum distribution, or RMDs, from tax deferred accounts.
Due to their tax deferred nature (and something called unrelated business taxable incomeI) it's generally recommended you own MLPs in taxable accounts, rather than tax deferred ones. REITs and BDCs can be owned in retirement accounts and thus put off non-qualified dividend taxes for years or even decades. However, in order to avoid dividend taxes entirely, there is just one legal option: the Roth IRA.
Here's a detailed guide to the differences between a Roth IRA and a traditional IRA as they pertain to dividend investing.
Concluding Thoughts on Dividend Reinvestment Taxes
Dividend reinvestments are taxed the same as cash dividends. While they don't have any unique tax advantages, qualified dividend reinvestments still benefit from being taxed at the lower long-term capital gains rate.
Dividend growth investing can be a great way for investors to compound their income and wealth over time, and DRIPs can help speed up that process. Like with all investments, just be aware of the important tax implications that come with this strategy.