Dividend Reinvestments: An IRS Blindspot

The Elephant’s Paycheck invest­ment strat­e­gy for 401K rollovers is sim­ple to under­stand. Invest in div­i­dend aris­to­crats and allow div­i­dend rein­vest­ments to ampli­fy your rewards.

What are div­i­dend rein­vest­ments?

When a com­pa­ny pays their div­i­dend, instead of tak­ing that div­i­dend as cash, you rein­vest the cash into the com­pa­ny in return for addi­tion­al shares.

The Benefits of Dividend Reinvestments

When you take your div­i­dend pay­ment in shares instead of cash, all your future div­i­dend pay­ments and Elephant’s Paycheck rais­es are larg­er than they would be oth­er­wise.

This real­ly isn’t dif­fer­ent than pur­chas­ing more shares, except for two key fac­tors:

  1. Dividend rein­vest­ments don’t (usu­al­ly) incur a trade com­mis­sion.
  2. Dividend rein­vest­ments don’t require whole shares to be pur­chased.

Both of these points are espe­cial­ly impor­tant for mod­est investors. Modest investors might not be able to invest very often, and if they do, even an $8 com­mis­sion could be sig­nif­i­cant. And, mod­est investors div­i­dends might not be enough to earn a whole share, but they can still par­tic­i­pate in the Elephant’s Paycheck Blueprint.

Importantly, when you accu­mu­late extra shares over time the long term ampli­fi­ca­tion of the absolute val­ue of your div­i­dend growth is dra­mat­ic.

The Drawbacks of Dividend Reinvestments

Assuming you’re using a bro­ker­age account, and not a div­i­dend rein­vest­ment plan, there is only one draw­back. And, that draw­back doesn’t apply if you’re invest­ing using an IRA (because it’s tax deferred).

The draw­back is that you owe tax­es on the div­i­dends received, in the year you receive them, even if those div­i­dends are rein­vest­ed. This fact is one of the things that pre­vents peo­ple from under­stand­ing the ampli­fi­ca­tion that div­i­dend rein­vest­ments give to your port­fo­lio returns.

How much tax? Not much. As of this writ­ing, the div­i­dend tax is 20%. Dividend tax­es are less than those on reg­u­lar income (fed­er­al­ly), and they don’t change the end result — that is, div­i­dend rein­vest­ments are a pow­er­ful way to juice your long term results and you might not real­ize that from look­ing at your bro­ker­age state­ments.

How Do You Start Dividend Reinvesting?

Every bro­ker­age account I know of allows div­i­dend rein­vest­ments to be turned on. If you rollover your 401K to a bro­ker­age, have a look under set­tings or give your bro­ker­age a call to find out how to turn it on. I use (and love) Fidelity. Fidelity lets me turn on div­i­dend rein­vest­ments on a per com­pa­ny basis (so it’s not all or noth­ing).

There’s anoth­er way to get start­ed. This is espe­cial­ly use­ful for mod­est investors, because the fees are triv­ial and you can get start­ed with as lit­tle as $250. You can often pur­chase stock direct­ly from large div­i­dend pay­ers. These accounts came about in a time when you had to buy stocks in “round lots” (mul­ti­ples of 100 shares) and com­mis­sions were in the hun­dreds of dol­lars. Direct pur­chase plans, also called div­i­dend rein­vest­ment plans, were used a way for small long-term investors to par­tic­i­pate in com­pa­ny own­er­ship. We’re not going to talk about div­i­dend rein­vest­ment plans here, but get in touch if you want more info.

What Does the IRS Have to Do with Your Elephant?

The IRS cares about how much tax you pay.

Brokerages there­fore need to report your finan­cial results in a way that helps you pay your tax­es.

Brokerage state­ments are a report­ing mech­a­nism to help you track your port­fo­lio in a way that helps you under­stand what you have, and how much tax you owe. They’re not a tool for edu­cat­ing you about invest­ing smarter.

Let’s imag­ine we invest $10,000 in a small busi­ness. If some time lat­er, that busi­ness is worth $15,000 we can all agree that the busi­ness has grown in val­ue by 50%.

If instead of start­ing a busi­ness, you cre­at­ed an Elephant’s Paycheck port­fo­lio, and some time lat­er it was worth the same $15,000 would the IRS say you had 50% growth?

No, they would not.

Remember, you’ve not added anoth­er pen­ny out of your pock­et. You’ve put that same $10,000 to work as the small busi­ness founder did, and at some point in the future find that it’s turned into $15,000. Why the dif­fer­ence?

The dif­fer­ence is tax­es.

Dividend reinvestments are tracked as two separate transactions, so the stock purchase appears to be a new investment.

Reinvesting div­i­dends is tracked as two sep­a­rate trans­ac­tions, so the stock pur­chase appears to be a new invest­ment.

Dividend rein­vest­ments are tracked as two dis­tinct trans­ac­tions so that the IRS can track the tax­es owed. First, the div­i­dend receipt (tax­es due this year). Second, the stock pur­chase (used as the cost basis for the future sale, which will have a tax impli­ca­tion). Brokerages don’t actu­al­ly real­ize these are two pieces of the same “event” from your per­spec­tive.

The IRS views an Elephant’s Paycheck port­fo­lio as hav­ing mon­ey added into for each of your div­i­dend rein­vest­ments. That’s just not the only way to look at it. Think of your port­fo­lio as a “side busi­ness”. Why would you mea­sure results any dif­fer­ent­ly than if you had opened a cof­fee shop? Or sell cook­ies out of your kitchen?

I’m not against pay­ing tax­es (or at least, I’m not against com­ply­ing with tax rules) but it’s not the only best way to mea­sure invest­ing suc­cess.

Especially when the account is a retire­ment account with deferred tax­es!

I hope it’s obvi­ous by now.

If you set­up a retire­ment account with $10,000, and at some point in the future have $15,000 you’ve grown by 50%. But you wouldn’t know that from look­ing at your bro­ker­age state­ment.

Let’s review this last bit.

Your bro­ker­age account state­ment mea­sures your suc­cess with div­i­dend rein­vest­ments in a way that helps you pay tax­es. Even if you’re not pay­ing tax­es1.

In doing so it under­states your return/success.

Of course, under­stat­ing your return changes your behav­ior — because as investors we’re seek­ing the great­est return we can get (in line with how com­fort­able we are with risk).

What does this mean?

It’s impor­tant to edu­cate your­self well to use div­i­dend rein­vest­ments as a tool to help your long term invest­ing suc­cess. You can’t rely on any­one else, even your bro­ker­age, to tell you how well you’re actu­al­ly doing.

A great place to start with your edu­ca­tion? The Elephant in the Room has a Paycheck invest­ing blue­print book.


  1. Even if you are pay­ing tax­es, your return is high­er than the IRS would help you believe. 

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2 thoughts on “Dividend Reinvestments: An IRS Blindspot

  1. Always rein­vest div­i­dends unless you need the cash (usu­al­ly a bad idea unless it’s in the short term), or are near/at retire­ment. Tax advan­taged plans are the best for it.

    That doesn’t mean you should not have them in reg­u­lar stock port­fo­lios as well, as taxed div­i­dends are still high­er then you would get in a sav­ings account now.

    • Exactly. Investing for div­i­dends, espe­cial­ly when you can “reduce risk” by using safe div­i­dends, a good strat­e­gy for long term invest­ing. Reinvesting the div­i­dends is very pow­er­ful over time.

      Thanks for vis­it­ing and shar­ing.