Investors pay dividend reinvestment tax on mutual fund dividends even if they reinvest the money back into the fund. Governments often treat dividend reinvestment tax and dividend disbursement tax as the same. Tax-protected retirement accounts can help investors avoid dividend reinvestment tax. Investors who purchase additional shares with fund disbursements also face capital gains tax.
A dividend reinvestment tax is paid by investors even if they never physically take possession of the fund’s dividends. Mutual funds and other investment companies pay dividends to shareholders which are included on the profits generated by the fund from transactions in the underlying securities. Rather than accepting these dividends as income, some investors choose to put the money back into the fund, in which case they often have to pay dividend reinvestment tax.
While many investors have to pay a dividend reinvestment tax, in many cases they are paying the tax because they earned the dividend rather than because they chose to reinvest the money by buying more shares in the same fund. If an investment company mails a dividend check to a shareholder, details of that disbursement are reported to the tax authorities, and the investor is normally required to pay income tax on those gains. When an investor chooses to reinvest a dividend instead of accepting a cash out check, fund operators continue to notify the tax authorities of the dividend payment and the investor still owes income tax on those funds. Some governments have separate tax bands for dividends paid and dividends reinvested, but in most cases the dividend reinvestment tax and the dividend disbursement tax for investors are the same thing.
In some countries, taxpayers can save money for their retirement years by investing money in tax-protected retirement accounts. When funds are withdrawn from these accounts, the investor must pay income tax and may also incur an early withdrawal penalty if funds are accessed before reaching retirement age. If dividends from a tax-protected investment are reinvested, the investor avoids having to pay dividend reinvestment tax because the money never leaves the tax-protected account. As a result, taxes on dividends and other account income are deferred until the investor liquidates the account or makes a withdrawal.
In addition to paying dividend reinvestment tax, investors who choose to purchase additional shares with fund disbursements also face capital gains tax on any gains they generate as a result of reinvesting dividends into the fund. The amount of dividends reinvested forms the basis of the investor’s cost and if the shares acquired with the dividends increase in value, the investor must pay capital gains tax on the realized gains. If the shares lose value over time, the investor may be able to claim a tax credit for the loss, but the investor cannot claim a refund of assessed taxes on the actual reinvestment of the dividends.
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