Figuring capital gains for a DRIP account

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Q. My wife and I have been purchasing stock in a DRIP account for our granddaughter since she was born. It was registered a custodial account. Each year, a 1099 in her Social Security number was issued, but she never filed taxes on these dividends, which were always under $100. Now she’s 21 and she sold the stock and has a capital gain, so she will need to file a return. Does she need to be concerned about all the older dividends?
— Grandpa

A. A DRIP, or Dividend Reinvestment Plan, is offered by many publicly-held corporations as a way to accumulate shares over time.

We took your question to Bernie Kiely, certified financial planner and certified public accountant with Kiely Capital Management in Morristown.

He offered this example:

Let’s say you and your wife were to purchase 10 shares of Procter & Gamble today for your granddaughter at $80.10 per share. The purchase would cost you $801.10.

Right now P&G’s dividend yield is 3.44 percent. This means that each quarter P&G would send you a dividend check in the amount of $6.89 — current price of $80.10 multiplied by 3.44 percent, divided by 4.

If your initial purchase were in the form of a DRIP, P&G wouldn’t send your granddaughter a check, Kiely said. Instead of a check, P&G would use the $6.89 to purchase an additional fractional share of P&G stock. The $6.89 would purchase 0.086 shares of stock. So now your granddaughter would own 10.086 shares of stock.

“Next quarter’s dividend would be $6.96 because she would get a dividend on the dividend,” Kiely said. “Over many years this compounding would really add up.”

So let’s say after many years, your granddaughter wants to sell all her accumulated shares. The question here is: “What is her tax basis?”

“Basis is tax speak for her accumulated cost. Her cost would be the sum of your initial $801.10 purchase plus all the quarterly reinvested dividends,” Kiely said. “Each reinvested dividend is actually a new and distinct stock purchase. The reinvested dividend is added to the cost basis even if the dividend was not taxable because your granddaughter’s income was too low.”

The good news, Kiely said, is many companies with DRIPs keep very good records of the accumulated costs for all the reinvested shares. Smaller companies may not have records that are as accurate.

“Do you best to try to estimate the total cost so she doesn’t pay too much in capital gains tax,” he said.

Email your questions to moc.p1532347216leHye1532347216noMJN1532347216@ksA1532347216.