Don’t overlook the shares that your dividends are buying. When you open a mutual fund account, you can choose to receive dividends as cash or have them reinvested. You can do this with stocks as well -- in a dividend reinvestment program or an employee stock purchase plan.
Usually, most people choose to have their dividends reinvested. Once the choice is made, the process is invisible and easily forgotten. Since you don’t ever see the money, it’s easy to forget that the money is being used to buy more shares. When you purchase shares through reinvestment, it’s as if you received the cash and then immediately turned around and purchased more shares.
Example: You purchase 100 shares of a mutual fund for $500 on January 10, 2010, and the basis of the shares you purchased is $5 per share. On December 15, 2010, you receive a dividend of $30, which is used to buy 5 more shares of the same mutual fund. The basis of these shares is $6 per share. This is important to know if you sell all your shares, or more than the 100 you originally purchased, because if you assume all the shares were purchased at the same price ($5 per share), then you’ll be paying more tax then you need to.