Dividends that are paid on shares of stocks are taxable as ordinary income on your income tax return, regardless if they are reinvested or received in cash. You must pay taxes on all dividends, reinvested or not, in the year in which you received them.
Dividend reinvestors should keep scrupulous records, including all statements, in order to determine the cost basis of shares when you sell them. The DRIP administrator will send investors (and the IRS) a 1099-DIV form at year-end, showing the taxable dividends paid.
In addition, when the company sponsoring a DRIP pays fees and commissions on the investor's behalf, the IRS requires that the investor report that amount as extra taxable income. The amount paid will show up on the 1099-DIV form, as well as on account statements.
On the other hand, any amount paid in fees and commissions reduces the capital gains when a stock is sold.
If all this seems complicated -- it is. A lifetime of DRIP investing may create a morass of tax obligations when the time comes to sell the DRIP shares, with at least four new cost bases of DRIP shares established each year (when dividends are reinvested) as well as when any OCPs are made.
This is where good recordkeeping is essential. Keeping track of DRIP purchases by using a computer with a good financial program can help enormously; many investors consider software (such as Quicken or Managing Your Money) essential to DRIP investing.
Of course, there is a good side to the tax consequences of DRIP investing: it acts as a deterrent to selling shares, thus promoting the concept of investing for the long term!
A few other strategies to keep in mind in keeping the IRS at bay include the following:
If you never sold your DRIP stocks, the DRIP shares would be left to your heirs as part of your estate. The market value for all the shares will be stepped up to their value on the date of your death (or as of the date six months following your death). This surely eliminates the need to establish the historical cost basis of DRIP shares!
If sale of the DRIP shares is absolutely required, the investor should consider selling all the shares in a particular DRIP at once. This will create just two entries on the investor's tax return, one for short-term capital gains from the last few quarterly reinvested dividends, and one for long-term capital gains (the sum of all the gains in the DRIP less the recent reinvestments).
Above all, the importance of recordkeeping cannot be overstated. Unlike other tax-related documents, DRIP statements, recording all reinvestments and OCPs, should be kept indefinitely.