Avoid Paying Taxes Twice on Reinvested Dividends by Karla Hopkins & Carolyn Flaherty

Many taxpayers get tripped up on this issue and end up unnecessarily paying tax on the same earnings twice. The key to avoiding double taxation on reinvested dividends is to keep track of the tax basis of your mutual fund investments. Your initial basis is what you pay for shares and your basis increases with each subsequent investment and each time dividends are reinvested in additional shares, (most mutual funds are set to automatically reinvest your dividends).

Some taxpayers neglect to increase the basis of their investment for dividends reinvested over time and therefore pay tax when the dividend is issued and again when the shares are sold, (when the reinvested dividends are not accounted for, the basis used to calculate tax is lower than it should be and therefore the taxable gain claimed is higher).

Many mutual fund companies now track an average tax basis for investors, however maintaining your own records can give you more flexibility to control your tax gains and losses. Average cost is only one method that can be used to determine your cost basis upon sale of shares. You can also specifically identify shares; choose the oldest shares in a "first in first out" method or newest shares, ("Last in first out"). Once you select a method to identify shares you must be consistent in its application. Specific identification gives you the most flexibility but also requires the most record keeping.

The flexibility of specific identification can be valuable for tax planning. For example, in a year that you have other gains, you may wish to offset the gains with losses and vice versa. If you sell a portion of the mutual fund, choosing those shares with the highest basis would lower your gain and selling those with lowest basis will increase your gain.

The general period of time that the IRS can audit your return is three years. However, you must be able to support amounts claimed on your return. Therefore, you must keep records until the actual liquidation of your investment without regard to the three year audit period. In other words, maintain records from the date of your original investment until the date you liquidate all shares in a mutual fund and then for an additional three year period in case you are selected for audit. Documentation and organization is imperative.

We suggest that you create an investment folder for each mutual fund and at a minimum keep the year-end statement for the fund that includes the share activity, purchases, sales and reinvestments for the whole year. Better still, maintain and update a spreadsheet or personal financial package like Quicken with your investment records. This way, in 10 years when you are liquidating shares, it is not overwhelming to determine your cost basis. Moreover you will have the information available to ascertain, with the assistance of your tax advisor, the most tax effective method for cost identification.