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Wednesday, March 05, 2008

Why reinvestments mess up your taxes

A couple of folks have asked me questions about my earlier post this week about dividends screwing up your taxes when you sell. Reinvesting your dividends accounts for 20 to 60 percent of the return on investments in the stock market, so one would think that you would want to turn it on, right?

It turns out that this is only true for tax-sheltered accounts such as a 401(k) or IRA. In taxable accounts, first of all, you are liable for taxes on the dividends --- so if you turn on dividend reinvestment, the taxes to pay those dividends have to come from somewhere. Even worse, however, is that dividends appear at quarterly or annual intervals not under your control! So when it comes time to sell the stock or fund, you'll end up digging through your records to see when all the reinvestments happen, how much you paid per share, and whether it's a long or short term capital gains tax. If you do this over a long enough period of time (such as 10 years), your brokerage might not have kept track of the reinvestments over that period, and now you're really stuck.

In fact, a friend of mine (a well known economist who occasionally writes for a national newspaper) once admitted that it was so complicated for him that rather than do the computation, he decided to just donate the stock to charity and wash his hands of the whole mess. If only we were all so wealthy that we could give away our capital gains like that!

Furthermore, what you really want to do with dividends is to stash them in some safe security, and use them to help re-balance your portfolio by buying more of the assets that are down. If you're in retirement, you probably want to spend your dividends first (or use some of them to pay taxes!), before selling any equity. So think twice before turning on reinvestment plans for your taxable accounts!

1 comment:

DWallach said...

Reinvestment is tolerable if (and only if) you can see everything in Quicken and you have Quicken set up properly (i.e., you've disabled dollar cost averaging). At that point, it's really no big deal to track the cost basis of every reinvestment. Still, your point is still valid that reinvesting a security's dividends into the very same security is not necessarily the optimal outcome for keeping your portfolio balanced properly.

So long as you're in a financial position where you're always putting money into your account (i.e., you're earning more than you spend and investing the remainder), then you can use that as a balancing mechanism. Of course, when you're retired and you're taking money out, you can similarly select which securities you want to sell in order to keep things properly balanced.