D is for DRIP.
A DRIP (or “DRP”), short for Dividend Reinvestment Program, allows shareholders to use stock dividends that would have normally been paid out as cash to purchase additional shares or fractional shares. In a basic DRIP, the dividends are used to buy more of the same stock.
Here’s a quick example:
Let’s say you have 40 shares of Coca-Cola stock that you bought for $800, now worth $1,000. This year, that same stock throws off a dividend of $10. Rather than opt to get a check for $10, you participate in a DRIP.
As of this morning, the shares were trading at $38.55/share. Rather than pocket the $10, you can reinvest it to buy more Coca-Cola stock. Using the $38.55 purchase price, you can buy .2594 share of Coca-Cola stock (generally, DRIP is not subject to broker fees).
It’s automatic so you don’t have to think about whether to buy: the decision is made for you. That’s the easy part.
What can be confusing for taxpayers is that, since they never see the cash in hand and they haven’t sold the stock, the assumption is often that the transaction is not taxable. That’s not true.
The DRIP doesn’t change the nature of the dividend. It’s still a dividend and you must report it on your tax return. You will receive a form 1099-DIV (or consolidated form) reporting the total amounts paid or reinvested. That information goes on your Schedule B.
It’s not necessary to indicate on your tax return that the dividend was reinvested. The Internal Revenue Service doesn’t care… for now.
You do want to keep good records, though, because the DRIP affects your basis. Since the dividends are used to buy more stock, it increases the value of the stock for purposes of capital gains. When you sell, you’ll use the original purchase price plus the reinvested dividends to calculate your basis for purposes of capital gains.
Referring back to our example:
Let’s say you decide to sell the shares next year for $1,200. Your capital gain is the selling price less your basis. The selling price is easy ($1,200). Your basis is the original basis of $800 plus your dividends ($10), or $810. Your capital gain is $390, or $1,200 less $810.
It’s important to track your basis because it’s easy to forget about those DRIP additions. Since you’re paying tax on them each year, keep good records so that when it’s time to sell, you don’t report more gain than necessary.
