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The last Investor Clinic column discussed dividend reinvestment plans. Judging from your responses, there's a lot of interest in DRIPs.

There's also a fair bit of confusion.

The confusion centres largely on the tax treatment of DRIPs. So today we'll try to answer some of your questions. And really, what could be more fun than reading an article about taxes on a hot summer day?

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Relax, we'll try to make this painless.

Are dividends in a drip taxed?

Unfortunately, the answer is yes. Even though your dividend is automatically reinvested in more shares and you don't actually receive the cash, Ottawa makes sure to get its slice of the action. You pay the same amount of tax on dividends whether they're part of a reinvestment plan or not. (We're referring here to investments held in a taxable account, of course.)

The good news is that dividends are taxed at a much lower rate than other forms of income. In Ontario, for example, someone earning a salary of $100,000 a year pays just 18.7 per cent on eligible dividends, versus 43.4 per cent on employment or interest income.

What happens when you sell your shares?

Here's where things get a bit more interesting.

When you sell your shares, you (or your accountant) must calculate your capital gain (or loss) to figure out how much tax you owe. Your capital gain is the difference between the amount of money you received for your shares and the amount you paid for them. (Any commissions incurred in buying or selling would reduce your capital gain accordingly.)

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Figuring out the proceeds of your sales is easy enough. The trickier part is calculating the cost of your shares, because you will have bought them in small increments and at various prices, usually over many years. This is the part that scares away many DRIP investors, who are overwhelmed by the thought of tracking all those itty bitty share purchases.

Different ways to track average cost

If you're organized, it doesn't have to be that onerous. Many DRIP investors use spreadsheets or financial software programs. There are also DRIP tools available on the Internet: A Google search turned up a product called DRIPWizard, though I have never used it and can't vouch for its quality.

Regardless of which method you use, the key thing is to track the average cost of your shares. The formula is actually quite simple: Your average cost is the total amount of money you have spent to purchase shares (including commissions), divided by the total number of shares you own.

"It's easier to do than most people think," says Robert Gibb, an avid DRIPper who lives in Victoria.

Mr. Gibb uses Quicken to track his average cost, but you can also do it with just a pencil and a calculator. For each stock you own, simply keep a running total of the money you've invested (your initial purchase, plus subsequent dividend reinvestments) and the number of shares you own. You'll have to update these numbers quarterly, or monthly in the case of some income trusts.

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When you decide to sell - even if it's only a portion of your holdings - you can quickly determine your average cost by dividing your total dollars spent by the total number of shares you hold. Once you know your average cost, calculating your capital gain is a piece of cake.

Let's look at an example. Say you've spent a total of $50,000 over the years to accumulate 2,000 shares of XYZ Corp. Your average cost is therefore $25 a share ($50,000 divided by 2,000). Now suppose you need a new boat and decide to sell 1,500 shares of XYZ, which are now trading at $40 a share.

Your capital gain would be $60,000 ($40 times 1,500) minus $37,500 ($25 times 1,500), or $22,500. Because Ottawa treats capital gains preferentially, you would pay tax at your marginal rate on only half of this amount.

As for the 500 shares of XYZ remaining in your account, your average cost would still be $25. Even though you sold some of your stock, the average cost of your remaining shares doesn't change.

The easy way out

There's an even simpler approach: Let's call it the "let someone else deal with it" method. David Stanley, a retired University of Guelph professor and a DRIP enthusiast, says he has no idea what the average cost of his shares is and "couldn't care less".

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Because he's not planning to sell any of his shares before he dies, he doesn't have to worry about calculating capital gains. That will be a job for his executor, to whom he sends statements regularly.

"I fobbed it off on somebody. Life is short and I have many things to do," he said. "I don't intend to ever sell my DRIPs and I've made arrangements for that to be done in the sweet hereafter."

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