Reinvesting dividends in a taxable account

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One of the most frequently asked questions on our forum is whether to reinvest dividends in a taxable account. This page discusses the pros and cons of taking dividends in cash in the taxable account. Below, the term "dividends" is used for brevity, but it should be understood as "dividend and capital gain distributions" to be precise.

Pros of taking dividends in cash
It is a good idea to take dividends in cash in several cases:


 * If you are planning to use specific identification of shares, taking dividends in cash avoids creating a lot of small tax lots.  You can invest dividends along with new money.
 * If you are planning to do tax loss harvesting, automatic reinvestments of dividends may accidentally trigger a wash sale.
 * If you are investing a relatively small amount of new money compared to the dividends you receive, taking dividends in cash may better facilitate rebalancing because you can choose not to put any new money (including dividends) into an outperforming fund.
 * If you have difficulty maxing out tax-advantaged accounts from your paycheck, and taking dividends from your taxable account would allow you to max out your tax-advantaged accounts, you may want to take dividends in cash and use the cash to max out your tax-advantaged accounts. (This situation may apply to investors who have inherited a large taxable account, or have built a large taxable account, ignoring the benefits of tax-advantaged accounts for many years.)
 * If your taxable account has a fund that is less than ideal but remains a suitable holding, you might want to take dividends in cash from that fund. For example, if you have Vanguard 500 Index Fund with a large amount of unrealized capital gains, and your asset allocation calls for Vanguard Total Stock Market Index Fund for domestic stocks, you may want to take dividends from Vanguard 500 Index Fund in cash to avoid investing more money into Vanguard 500 Index Fund.
 * For retirees withdrawing income from taxable accounts, taking dividends and capital gains distributions in cash simplifies tax accounting.

Cons of taking dividends in cash
Although taking dividends and capital gain in cash generally simplifies cost basis accounting, there are several caveats.


 * If you have your mutual fund or brokerage automatically reinvest distributions back into a fund with a purchase fee, shares purchased with the distributions are not subject to the purchase fee (at Vanguard, the Vanguard Global Ex-US Real Estate Index Fund imposes a purchase fee). However, the savings with automatic reinvestment are extremely small. If you assume 2% distributions from a fund with a 0.75% purchase fee, the purchase fee is 0.02% of the fund balance.
 * If you have your mutual fund or brokerage automatically reinvest distributions back into a fund with a permanent redemption fee (such as, for example, the Vanguard Global Ex-US Real Estate Index Fund), shares purchased with distributions are subject to the fee. However, if the fund imposes a short-term redemption fee, the shares purchased with distributions are usually not subject to a redemption fee if you redeem them within the short-term redemption fee period. This feature is specific to a fund.
 * There is a small opportunity cost for not investing dividends immediately. See Delaying reinvestment of dividends for more details.

Observations

 * There is no extra tax cost for reinvesting dividends, versus receiving cash and buying shares. Either way, the newly-added shares have a basis which is subtracted from the sale price of those shares to compute the capital gain when you sell.
 * The decision to take dividends in cash does not require you to use specific identification of shares or do  tax loss harvesting.
 * If you are planning to use average cost basis, the reinvested shares will have the same average basis as all previous shares. If your next transaction in the fund is to sell shares, you will probably have a taxable capital gain, which you could have avoiding by taking the dividend in cash.  Therefore, you will have an extra tax cost if you reinvest the dividend when you are likely to need to sell shares, either to spend money or to rebalance out of the fund.
 * The share price in a bond fund does not vary significantly, so there is little potential tax cost to reinvesting dividends and selling those shares later. (However, since most bond funds distribute dividends monthly, you will always have a wash sale if you sell any shares for a capital loss, which is an accounting complication even if it doesn't cost you a significant amount in taxes.)