Every company that generates a profit has three choices for using the earnings: reinvest in the company’s business, reduce debt obligations, or pay a dividend to shareholders.

A dividend-paying company typically does so quarterly, in cash. Mutual funds also usually pay quarterly, as they are required to pass along to shareholders any dividends they receive from companies in their investment portfolios. And, for investors who receive dividends—including those reinvested in a company or fund’s shares—there can be tax liabilities.

How dividend reinvestment works

Shareholders have two choices for the dividends they receive: take the cash and spend it as they wish, or use the dividends to buy more shares in the company or fund. This is known as dividend reinvestment.

Reinvestment of stock or fund dividends can help build an investor’s wealth over time by compounding returns. For example, say an investor owns 100 shares of XYZ Inc. valued at $10 each, for a total value of $1,000. XYZ declares an annual dividend of $1 a share, so the investor will receive a dividend of $100. By reinvesting, the investor can buy 10 more shares at the current price, owning 110 shares total, valued at $1,100.

If XYZ’s stock price rose, to $15 for instance, the investor’s 110 shares would be valued at $1,650. Another investor with 100 XYZ shares who took the cash dividend would have $1,600—100 shares at $15 each, or $1,500, plus the $100 dividend uninvested.  These gains on reinvested dividends compound over time, assuming XYZ has steady earnings, dividend growth and its stock price rises.

If you're curious about how compounding could potentially affect your investment returns over a period of time, check out Titan's Compound Interest Calculator.

Taxes on dividends

Stock dividends, as well as those paid by mutual funds, usually are taxable, unless they are derived from investments held in a tax-advantaged account such as a 401(k). This includes dividends used by investors to reinvest in the company or fund shares. Taxation can be either at the investor’s regular income tax rate, or a lower long-term capital gains rate depending on the investor’s tax bracket and the length of time the dividend-paying shares are owned.

The Internal Revenue Service classifies dividends in two ways: qualified and unqualified.

Qualified dividends

These qualify for a lower tax rate, called the long-term capital gains rate, as long as:

• They were paid by a U.S. company or a foreign company meeting certain IRS criteria, such as having tradable shares in the U.S. (for example, American depositary receipts—ADRs).
• The shareholder owned the shares for at least 60 days during a four-month period straddling the ex-dividend date.

There are three rates: zero, 15% and 20%. The tax rate on qualified dividends depends on an investor’s filing status and taxable income. Here is a breakdown for the 2022 tax year:

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Non-qualified dividends

These don’t meet IRS requirements for lower capital-gains tax rates, so they are taxed as ordinary income, based on an investor’s tax bracket.

Dividends from real estate investment trusts (REITs), master limited partnerships (MLPs), employee stock options, and money market accounts are non-qualified. So are special dividends, dividends on shares underlying stock options or shares used for short selling, a strategy to profit when a stock’s price falls.

The chart below shows how much difference a qualified dividend tax rate can mean to an investor, compared with the regular income tax rate.

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When are reinvested dividends not taxable?

Retirement accounts are the way investors can reinvest dividends that compound the growth of their nest eggs, while minimizing the impact of taxes. Investors will someday pay taxes on the dividends: It’s simply a choice of paying taxes now, or later, depending on the investor’s circumstances and choice of account.

There are two main options for retirement accounts: tax-deferred and tax-exempt.

Tax-deferred

These include individual retirement accounts (IRAs) and 401(k) accounts, allowing contributions to accounts to be deducted from taxable income. Similar plans exist for public-service employees such as teachers, nurses and librarians (403(b) plans), and for state and local government employees (457 plan). There are limits, however, on how much an investor can put into these plans.

Dividends and capital gains in these accounts are tax-deferred, and can be reinvested, while money is accumulated for retirement. Tax-deferred retirement plans require investors to leave the money in the accounts until they reach an age the government considers a minimum retirement age, currently 59 1/2. Once investors start withdrawing money from tax-deferred retirement accounts, the withdrawals are taxable income.

Tax-exempt

Roth IRA

and Roth 401(k) accounts, in contrast to tax-deferred accounts, let investors make contributions with after-tax income. That means they get no tax deduction up front. Once contributed, any money in Roth accounts grows tax-free, including dividends generated from account investments. When the investor starts withdrawing for retirement, they won’t pay taxes on it.

Most investors use tax-deferred IRAs and 401(k) plans as part of a strategy to postpone paying taxes until retirement, when their income and tax bracket may be lower. Roth accounts tend to appeal to younger investors who start with lower incomes and tax brackets, and who decades later can enjoy tax-free income even if they have moved into higher tax brackets.

How are dividends reported on tax returns?

Dividend payments are reported to the IRS on Form 1099-DIV, which includes a breakdown into qualified and non-qualified dividends. Dividends of at least $10 must be reported to the IRS. If an investor received more than $1,500 in dividends for the year, a Schedule B for interest and dividends must be included with the tax return.

The bottom line 

Retirement accounts are a popular way for investors to build wealth with some tax advantages, including tax-free reinvestment of dividends, which can compound the growth rate as investors work toward retirement. Tax-deferred accounts allow investors to make tax-free contributions and reinvest dividends tax-free until retirement, and then pay taxes; tax-exempt accounts by contrast allow investors to benefit from tax-free income after retirement, in return for making contributions from after-tax income before retirement.