Can Reinvesting Dividends Really Save You on Taxes?

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Investing and taxes are understandably confusing to many investors — many of us have big questions about how our investments impact our taxes. That's why it's important to clarify some of the most common misconceptions, such as the belief that reinvested dividends aren't subject to taxation. In fact, according to the National Association of Enrolled Agents, it's one of the top 10 misconceptions about taxes. And it's a misconception that could cost you big bucks at tax time. (See also: The 10 Worst Tax Moves You Can Make)

Read on to take better control of your money by learning some basics about investing and taxes and banishing some common myths.

What Dividends Are

Cash dividends are distributions of a business's profits to its investors. Typically, the board of directors announces a dividend and issues payments on a quarterly or annual basis. Stock investors receive dividends based on the number of shares held. For example, Coca-Cola paid quarterly dividends of $.305 in 2014 or $1.22 on each share; if you held 100 shares, then you received $122 in dividends.

Not all profitable publicly-held companies issue dividends. Typically, dividend-paying corporations are stable ones who have a history of generating enough cash to pay the bills, set aside money for future needs, and share profits with shareholders.

Some companies declare stock dividends, which are similar to stock splits. In these situations, investors receive shares (or partial shares) of a company's stock based on the number of shares held. In some cases, shareholders are given the option to receive these dividends in cash.

What Reinvesting Is

Reinvesting dividends involves using money generated by cash dividends to purchase additional shares of stock in the dividend-paying company.

Many brokerage firms make reinvesting dividends super easy. When you open an account, you simply check a box to indicate that you want to reinvest dividends. If it's the default selection, you may already be signed up for this service without knowing it.

When dividends are distributed, additional shares of the original investment are automatically purchased for your account. You can determine if you are buying shares in this manner by reviewing your statements or viewing detailed transactions on the dashboard of your brokerage account. If you have elected to reinvest dividends, then you will notice that shares (generally small amounts or partial shares) have been purchased automatically on your behalf.

Many younger investors opt to reinvest dividends in order to acquire additional shares and continue growing their wealth, without needing extra cash. Alternatively, many retired investors may choose to take dividends in the form of cash as a means to help cover living expenses.

Why Dividends Are (Sometimes) Subject to Tax

Dividends may be subject to taxes because they represent income to you, the investor. Again, the folks at the IRS don't care that your brokerage firm reinvests the cash for you. What's significant is whether you are eligible to receive cash within a taxable account. What you do with the money is irrelevant to the tax situation.

However, if the investment is held in a tax-advantaged account, such as an IRA, 401(k) plan, or 529 plan, then generally you don't owe taxes on dividends. So, your tax situation in this case depends on the type of account, not whether you receive cash or automatically reinvest the dividends.

More on Investing and Taxes

Another area of confusion in regard to investing and taxes is the treatment of stock market losses. Specifically, many taxpayers are mistaken when they believe that they don't have to report losses — or that the losses they do report can offset all of their ordinary income.

While you typically don't need to report "paper losses" (declines in investment values) or losses that occur within a tax-advantaged account, you should report any losses realized in a taxable account. These losses can offset capital gains and ordinary income, saving you money at tax time.

Generally, you can counteract just $3,000 of your ordinary income with stock losses, not the entire amount of your annual earnings (which is likely to exceed that number anyhow); however you can carry over your losses and deduct them from income in subsequent years.

Understanding taxes on investments isn't always intuitive, and regulations change frequently. Protect your pocketbook by staying up to date with any changes and consulting an investment or tax professional when in doubt.

Are you clear or confused about investing and taxes? How do you stay on top of tax regulations and constant changes?