How do dividends affect your average cost (both re-invested and non re-invested)

Question

I have read that re-invested dividends lower your taxes by increasing your average cost of the security so that when you sell your security, the difference between the sales price minus the book value (which includes re-invested dividends), becomes less compared to if you didn't re-invest your dividends. i.e. it reduces the capital gains.

So, just to confirm, if you don't re-invest your dividends, are you losing out on this potential to minimize your capital gains because the dividends are paid out in cash and then you just get taxed on it at the end of the tax year and when you sell your investment, you potentially will have a larger difference between the sale price and book value (assuming your security increased in value), and thus pay a higher capital gains tax.

I'm interested in Ontario, Canada tax jurisdiction for 2014.

Answer 1

No dividends don't lower your capital gains taxes. Realize that the same capital gains tax is still owed on the original purchase. A lesser amount will be owed on the shares purchased with dividends if bought at a higher price. In Canada there are no 'tax lots' so all shares held by you (and your spouse) will have the same average cost.

In one contrived scenario it may seem like less tax is owing and that's where you don't sell all the shares, however in this case it's just better not to reinvest the dividends.

A better strategy is to buy a similar fund and then sell the one with the highest cost base when you need money. This still doesn't lower your taxes, just defers them until the eventual sale of the original shares.

I've been using 'dividends' instead of 'distribution' as in your question but most funds have distributions that have components with different tax characteristics. One worth mentioning is 'return of capital'. In this case your cost base decreases by the ROC amount but no tax is immediately owed.