How to Pay Taxes on Dividend Reinvestment Plan (DRIP) Stocks

Through a dividend reinvestment plan (DRIP), it is possible to amass tens of thousands, if not, hundreds of thousands of dollars over the long term. As with any investment, however, tax considerations come into play that will subtract away from your bottom line. With DRIP stocks, you will be responsible for paying taxes on realized capital gains and dividends. To report your DRIP account activity to the IRS, you must first identify the right paperwork.

Tax Paperwork

At tax season, you will receive 1099 forms from your dividend reinvestment plan administrator, which document your investment activity. You will use this information to complete IRS Schedule D to report your dividends and capital gains to the IRS. From there, you will attach Schedule D to your 1040 and include your investment gains within taxable income.

DRIP Dividends and Taxes

For tax purposes, dividends are classified as ordinary and qualified dividends. In 2011, ordinary dividends are taxed at ordinary income rates of 10, 15, 25, 28, 33, and 35 percent. Alternatively, qualified dividends are either tax free or taxed at maximum 15-percent rates. For qualified dividends, you must hold shares of stock for at least 61 days out of the 121-day holding period that surrounds their ex-dividend date. You must buy and hold shares prior to and through their ex-dividend date to collect dividends by the next payable date. With a DRIP account, the majority of your dividends are likely to be recognized as qualified dividends. A DRIP account is structured to favor long-term investing, rather than the short-term trading that generates ordinary dividends.

Realized Capital Gains Taxes

With a DRIP account, you owe taxes when you realize capital gains, or sell off your investment at a profit. Similar to dividends, realized capital gains also feature a dual tax structure. Short-term capital gains are taxed at the higher ordinary income rates, while long-term capital gains are either tax free or taxed at maximum 15-percent rates. With a DRIP account, you can purchase fractional shares with every investment installment, which should make for easier tax accounting. For example, you could buy $500 each month of Oil Company X for the year, which translates into a $6,000 investment. After three years, your Oil Company X position grows to $10,000, before you sell it off. You would then owe taxes on $4,000 worth of long-term capital gains.

Realized Capital Losses

If your investments fail to perform, you can deduct $3,000 worth of realized capital losses away from your taxable income. DRIP account losses that exceed $3,000 can be carried forward as deductions for subsequent years. Be advised that the IRS prohibits wash sales for the sole purpose of taking a tax write off. A wash sale occurs when you sell a stock and immediately buy it back within the next 30 days.

Investment Strategy

When investing money through a DRIP, your ultimate goal remains to earn the highest returns for the least amount of risk. An ideal risk versus reward balance does not always translate into minimal taxes. For example, you should not purposefully hold onto a losing DRIP account simply to use it as a tax write off.

How to Pay Taxes on Dividend Reinvestment Plan (DRIP) Stocks, Sources:

SEC: Direct Investment Plans - Buying Stock Directly from the Company

IRS: Dividends

IRS: Capital Gains and Losses

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