The Biggest Tax Mistake by Equity Market Investors:

There are all kinds of investment gurus and brokers out there touting the power of reinvested dividends to grow the value of your portfolio over stretches of years.

So the guru explains to you how much richer you will end up with the power of compounding and the power of reinvested dividends.

But here's the equally important thing the investment guru should be emphasizing: If you are reinvesting your dividends, that is in-effect the same thing as if you had actually received that dividend check and then used that money to buy more shares. They just take care of all that for you by reinvesting the dividends you earned straight into buying more shares  without going through the whole rig-a-ma-roll of sending the dividend money to you and you sending it right back to them to buy more shares.

What this means for tax purposes is that these reinvested dividends increase your cost basis of your position. Let's do a math example here. You buy $2,000 worth of coca-cola stock. (Coke has an automatic dividend reinvestment program, as do many companies). Lets say you hold that position for five years. You never send any more money directly to buy more shares yourself,  but, lets say each year you were granted $100 in dividends. They didn't send you that $100 each year, they just reinvested it for you into more shares of coca-cola stock. Then at the end of your five years, lets say you sold your entire position in coke for $3700.

Question: How much was your capital gains?

Answer: your capital gains in this case is only $1200 not $1700. This is the most frequent common mistake made by equity investors.  The $500 of reinvested dividends is just as if you had sent in $500 yourself to purchase more shares. You do not have to pay tax on that money now when you sell, because you already did pay tax on it over the last five years. For each of those five years that you received $100 in dividends each year, even though you never physically received the check, you still had to pay your tax on that $100 dividend.  This is really the key concept here. Since you already paid income tax on those dispersed dividends so you do not have to pay income tax on them again. This is the number one mistake equity investors make and they end up paying double income tax on those dividends because of it.

The exact same thing applies to short term capital gains realized by mutual funds. If a mutual fund realizes short term capital gains, it must disperse those gains to the shareholders of the mutual fund exactly the same as dividends. Please don't forget short term capital gains distributions from mutual funds. They are handled exactly the same situation as the dividends. They increase your cost basis in your mutual fund shares you own. You paid your income tax on those gains each year you received them and if you are reinvesting them, make sure you know those increase your basis. A lot of people drop the ball on this. By the time they sell they've forgotten about the reinvested dividends so they accidentally just pay tax on them again.

Capital Gains Tax by Tax Bracket and Year: