Yes reinvested dividends are taxable income.
Assuming you’re reinvesting dividends in a regular taxable account. If you’re using a 401k rollover / IRA account, then reinvested dividends are not taxable.
The thing is, you probably mean to ask…
Will I be stuck with a big tax bill that I’m not prepared for at the end of the year if I reinvest my dividends?
If you are just getting started investing, probably not.
Federal taxes on dividend income is 20% (state and local taxes vary by municipality). So, for a rough estimate you can assume you’ll owe 25% of dividend income as taxes.
If you’re just getting started, like reader Roshan J who sent me the following message recently, and you have $500 in dividend income, you’ll owe about $125 taxes.
I was doing my taxes over the weekend. I’ve been investing in dividend stocks for the past say year and a half. And in 2016 I got a total of about $500 in dividends. Which was surprising. Imagine doing this over many years? I can see that snowball effect really coming through.
But, and it’s a big but, what you owe depends a lot more on how much you have taken out of your paycheck. Do you have a lot of exceptions so that you get a big refund at the end of the year? Well, then your refund will be just a little smaller.
If you’re like me when I started investing, I found the deductions taken out of my paycheck were so innacurate as to make the amount of taxes I owe on dividends a rounding error. Meaning, I didn’t consider dividend income because they didn’t make a meaningful difference in taxes owed relative to my paycheck’s taxes.
Currently though, I have a meaningful amount of dividend income outside of my retirement account so I do pay quarterly estimated taxes. If you’re in a position to doing that, you should be working with a tax person who can give you advice relevant to your personal situation.
Personally, my feeling is that if you’re just getting started pay the taxes out of pocket as a way to accelerate your wealth building (instead of selling stock or not reinvesting all your dividends in order to pay them).
When I first started writing The Elephant in the Room has a Paycheck I put together a short story about how we measure the wrong things when evaluating our investments. Looking at reinvested dividends as two separate transactions (dividend income, then separately a stock purchase), while required to properly prepare taxes, isn’t the most useful way to think about reinvested dividends.
That story got picked up a bit, and had over 32,000 views! You can read it on slideshare.
Let me know what you think