No one likes to pay more in taxes than they have to, and many investors who own dividend-paying stocks don't need the income immediately and prefer to reinvest their dividends into additional shares. By doing so, many investors hope that they can avoid taxes on the dividends, but the tax laws aren't that generous.

Paying the piper
The tax laws recognize two different types of dividends. The most common in modern times is the cash dividend, whereby a company pays a certain amount of cash to shareholders for each share of stock they own. Even though all shareholders have a right to receive that cash, some companies allow you to have the cash automatically reinvested into new shares of stock. Moreover, even when a company doesn't offer a reinvestment option, some brokerage companies offer their clients the same service.

Many investors believe that they shouldn't have to pay tax if they reinvest their dividends. After all, they never actually received cash, so they argue that there's no true income involved. Moreover, they can point to the way that the tax law treats capital gains, where you don't have to recognize taxable income until you actually sell the shares.

Despite their belief, investors do have to report dividends as taxable income even if they reinvest them to buy more shares. Companies and brokerage companies will report such dividends on 1099-DIV forms the same way regardless of whether you reinvest in new shares, and the IRS will expect you to include them on your annual tax return.

A dividend that doesn't incur tax
By contrast, the other type of dividend, the stock dividend, has different tax treatment. Stock dividends aren't taxed at the time they're made if recipients have no option to receive cash instead. Instead, you recognize any income when you sell the shares you received as part of the stock dividend. Most companies don't make extensive use of stock dividends, reserving them to execute major changes like stock splits.

If you're trying to decide whether to reinvest your dividends or take them as cash, tax considerations will rarely play a major role. Instead, you should make a decision based on whether you need the income and whether the stock remains a good investment.

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