Ask the Expert: Should reinvested dividends be added to the cost basis?

In your Jan. 2 column, you addressed how cost basis is arrived at when mutual fund shares are sold. What about all the reinvested dividends, which were reported to the Internal Revenue Service annually on Form 1099. Taxes were paid on them. Shouldn't they be added into the cost basis?

Yes; otherwise, you’ll pay taxes on them twice.

The Jan. 2 column was about the tax treatment of a non-retirement mutual fund jointly owned by a married couple after one spouse dies. Tax law says each spouse owned 50% of their joint account. As a result, the survivor inherits half the shares; he or she already owns the other half. The survivor's cost basis in the inherited shares is their market value at the time of the deceased spouse’s death. The cost basis on the shares the survivor already owned is their original purchase price.

The simple example I gave to illustrate this rule didn't include reinvested dividends. Here's one that does.

Let's say the couple originally invested $1,000, and over time reinvested an additional $800 in dividends.

When one spouse dies, the investment is worth $2,500. The survivor sells all the shares for $2,500.

Her cost basis in her inherited shares is their $1,250 current market value.

The cost basis of the shares she already owned is the initial cost of $500 (her half of the couple's original investment), plus $400 (half of the reinvested dividends). That's $900.

Her total cost basis for the $2,500 account is therefore $1,250 (her inherited shares) + $900 (her own shares) = $2,150. Her taxable profit is the $2,500 sale price minus the $2,150 cost basis = $350.

The bottom line

When you sell shares from a non-retirement account, the dividends you reinvested are included in your cost basis.

More information

irs.gov/taxtopics/tc703

intuit.me/3qp0WkX