If you're heavily invested in mutual funds, chances are good that you've thought through the tax implications of your holdings. For instance, you're probably aware that long-term capital gains are taxed at lower rates than short-term capital gains. As such, it's almost certain that you hold your mutual fund investments for longer than a year before selling them for a profit. If you're like most mutual fund investors, you might hold shares in the same fund for far longer than 12 months. Since it's notoriously difficult and expensive to divest from one mutual fund and purchase shares in another, many investors simply stick with their "original" funds. In many cases, this works out well.
You may also choose to reinvest the dividends that your mutual fund accrues. Investors who prefer not to reinvest their funds' dividend distributions enjoy access to sizable cash windfalls at regular intervals throughout the year. These windfalls can be withdrawn from their funds' accounts or manually reinvested in other investment vehicles. Since this option confers a tremendous amount of choice and freedom, many investors choose to operate in this manner. Unfortunately, manually reinvesting or withdrawing dividend distributions may provide sub-par long-term returns. In many cases, the best course of action is simply to reinvest any dividend payments that the fund accrues.
Since they accrue additional value in accordance with the principles of compound interest, automatically-reinvested dividends tend to produce greater out-year returns. Dividend-paying fund components that enjoy even modest yields may double or triple in value within a decade's time on the strength of this compounding principle. Investors who wish to take a hands-off approach to investing can simply leave their fund shares untouched and enjoy meaningful long-term growth.
Unfortunately, reinvested dividends aren't subject to any special tax breaks, credits or loopholes. Even though you don't technically have access to the reinvested funds, they're considered regular income for the purposes of taxation. Since many investors aren't aware of this fact, it has become a major point of contention between mutual fund issuers and their clients. In fact, many investors have lobbied to change the tax code's treatment of reinvested dividends.
If you're enrolled in a dividend-reinvestment program, you'll need to pay taxes on your reinvested dividends. You'll also need to pay taxes on any gains that accrue as a result of those dividends. In order to avoid "double taxation" on your dividend earnings, be sure to include any reinvested dividends as part of your fund's cost basis.