We are often asked the question regarding whether or not it’s advisable to reinvest the dividends or capital gains distributed by mutual funds. In non-taxable accounts such as IRAs, there’s really no problem with reinvesting, since distributions are taxed as ordinary income when withdrawn. And while you may have some cost basis as a result of post-tax contributions, the distributions of dividends and capital gains have no affect on the cost basis in tax-deferred accounts.

There’s no problem in taxable accounts, either, if you keep good records. Often, however, people make the mistake of not adjusting their cost basis by adding to the cost of purchases, the value of the reinvested dividends and capital gains that have been distributed. If this is not taken into consideration, you will end up paying tax twice on the dividends and capital gains.

Why is that, you ask? Dividends and capital gains are reported annually to the IRS on Form 1099. You must include the distributions on your tax return, annually and pay the tax due. If you don’t adjust your cost basis when the holding is sold, you’ll pay tax again on the distributions you’ve received.

Reinvesting dividends and capital gains in taxable accounts can make record keeping a bit more difficult when you sell taxable assets. It’s not really a problem if you sell the entire holding, including all the reinvested shares. If, however, you sell part of a holding, then you must determine which lot, lots or partial lots were sold. This can be a bit more involved, even if you have good records. Therefore, you may want to avoid reinvesting dividends and capital gains in your taxable accounts.

Our recent blog titled “Good News for Some, Bad News for Others” (October 26, 2010), discussed the fact that brokers will be required to keep track of the cost basis information for you going forward. Nevertheless, you will still have to specify what lots you are selling when you sell part of a holding. If you don’t reinvest in taxable accounts, specifying lots will be easier.