No one likes paying taxes, but you know how the saying goes: There are only two certainties in life, and death is the other one.
When a depositor closes a savings account, the bank pays him exactly the same number of dollars that he deposited. If he left his interest on deposit, the bank has added that to his principal, but he is supposed to have reported that interest as taxable income. There is no question of a gain or loss in value of principal.
But when a shareholder sells stock, he is almost certain to have either a gain or loss in the dollar value of his principal. Now how do we treat this change in value? Does it affect principal or income? The federal income-tax rule is that when the seller has owned the stock for not more than six months, a gain in value is taxable income, and a loss is subtracted from income. (We omit some tax technicalities.) Since only a speculator is apt to sell stock as soon as six months after he buys it, we need not discuss this part of the tax rule.
When a man has owned stock for more than six months, the tax rule is that he has a "long term" gain or loss, and half of it goes into taxable income. Suppose a man paid $1,000 for stock, and ten years later he sold the same shares for $2,000, a gain of $1,000. According to the tax rule, in the year of sale he has $500 extra income, and the other $500 presumably he should add to his principal. There is plenty of argument about the fairness and wisdom of this rule.
A shareholder in an investment company encounters this same question, even though he never disposes of any shares of stock. Nearly all investment companies, from time to time, sell some of the stock they hold; and on a company's total sales during a year, if it receives more than it paid for the same stock it must pass this capital gain on to its own stockholders as a capital-gain dividend or distribution. For a stockholder, the federal tax rule says this distribution is a long-term gain, so that half of it is taxable income. Most of the investment companies pay a capital-gain dividend in the form of additional shares of stock, except when a stockholder asks for cash. But whether paid in new shares or cash, the federal tax rule says half of the dividend is income.
Regardless of the tax rules, it is more conservative for a stockholder not to spend capital gains, whether received as proceeds of a sale or as dividends. Here are some reasons:
1. Obviously these gains show up only when prices are higher than formerly. Later on, if a stockholder is obliged to sell stock when its price is low, he will wish he had reinvested his gains in the palmy days.
2. His future income dividends will be larger if he reinvests capital gains.
3. Future inflation may cut the buying power of some of his investments, or his pension income, and to offset this he may need to reinvest capital gains on stock. We will return to this point shortly.
4. Capital gains are so irregular in amount that if they are considered as spend able, they had better be averaged over enough years to make their spending a fairly uniform amount per year. On an investment company's capital-gain dividends, probably averaging for ten years is desirable. But reinvesting them all is simpler!
The smart and conservative investor will always put a little bit away for a rainy day, and reinvesting capital gains is an easy way to do this. This also avoids the need to pay taxes and keeps one's investment padded.