A dividend reinvestment tax is paid by investors even if they never take physical possession of fund dividends. Mutual funds and other investment companies pay dividends to shareholders that are comprised on earnings the fund generates from trades involving the underlying securities. Rather than accepting these dividends as income, some investors choose to reinvest the money in the fund in which case they often have to pay the dividend reinvestment tax.
While many investors have to pay a dividend reinvestment tax, in many instances they are paying taxes because they earned the dividend rather than because they chose to reinvest the money by purchasing more shares of the same fund. If an investment company mails a dividend check to a shareholder, details of that disbursement are reported to the tax authorities and the investor normally has to pay income tax on those earnings. When an investor opts to reinvest a dividend rather than accept a disbursement check, the fund operators still notify the tax authorities about the dividend payment and the investor still has to pay income tax on those funds. Some governments have separate tax brackets for disbursed dividends and reinvested dividends but in most instances investor the dividend reinvestment tax and the dividend disbursement tax are one and the same.
In some nations, taxpayers can save money for their retirement years by investing money in tax-sheltered retirement accounts. When funds are withdrawn from these accounts the investor must pay income tax and may also incur an early withdrawal penalty if funds are accessed before reaching retirement age. If dividends from a tax-sheltered investments are reinvested then the investor avoids having to pay the dividend reinvestment tax because the money never leaves the tax-sheltered account. Consequently, taxes on the dividends and the other account earnings are deferred until the investor liquidates the account or makes a withdrawal.
Aside from paying dividend reinvestment tax, investors who choose to buy additional shares with fund disbursements also have to contend with capital gains tax on any earnings that they generate as a result of reinvesting dividends in the fund. The amount of the reinvested dividends represents the investor's cost basis and if the shares bought with the dividends rise in value then the investor must pay capital gains tax on the realized earnings. If the shares lose value over time the investor may be able to claim a tax deduction for the loss but the investor cannot claim back the taxes that were assessed on the actual dividend reinvestment.