When selecting a mutual fund, an investor is faced with a number of big choices. Among the more confusing decisionsis the choice between a fund with a growth option and a fund with a dividend reinvestment option. Each type of fund has its advantages and disadvantages, and deciding which is a better fit will depend on your individual needs and circ*mstances as an investor.
Key Takeaways
- Mutual fund investors who don't want to take their dividend payouts can choose from either a growth option or a dividend reinvestment option.
- With a growth option, the investor lets the fund company invest the dividend payments in more securities and ultimately grow their money.
- With dividend reinvestments, fund managers are allowed to use dividend payments to buy more shares in the fund on behalf of the investor.
- Individual retirement account (IRA) holders can't take dividend payments ahead of retirement without penalties and, instead, must opt to reinvest.
Mutual Funds With a Growth Option
The growth option on a mutual fund means that an investor in the fund will not receive any dividends that may be paid out by the stocks in the mutual fund. Some shares pay regular dividends, but by selecting a growth option, the mutual fund holder is allowing the fund company to reinvest the money it would otherwise payout to the investor in the form of a dividend. This money increases the net asset value (NAV) of the mutual fund.
The growth option is not a good one for the investor who wishes to receive regular cash payouts from their investments. However, it's a way to maximize the fund's NAV and, upon the sale of the mutual funds, realize a higher capital gain on the same number of shares they originally purchased. This is because all dividends that would have been paid out have been used by the fund company to invest in more stocks and grow clients' money. In this case, the investor does not receive more shares, but their shares of the fund increase in value.
Mutual Funds With a Dividend Reinvestment Option
The dividend reinvestment option is quite different. Dividends that would otherwise be paid out to investors in the fund are used to purchase more shares in the fund. Again, cash is not paid out to the investor when dividends are paid on the stocks in the fund. Instead, cash is automatically used by the fund's administrators to buy more fund units on behalf of the investors and transfer them to individual investors' accounts.
This method increases the number of shares owned over time and typically results in the account growing in value at a faster rate than if dividends were not reinvested. Many investment companies offer this service to shareholders at no cost.
Investors realize a capital gain upon the sale of their units in the fund, which in the case of the dividend reinvestment option will probably be more fund units than they started with.
Whether you choose a mutual fund with a dividend reinvestment option or a growth option, you are opting to forfeit regular dividend payouts in favor of allowing the fund to use that money to grow your holdings.
Selecting a Dividend Distribution Option
In most cases, it is up to shareholders whether they prefer to have dividends reinvested or paid out.An exception to this would be in the case of individual retirement accounts (IRAs). Dividends inIRAaccounts must be reinvested by shareholders who have not yet reached retirement age so they do not incur early withdrawal penalties from the Internal Revenue Service (IRS).
Dividend Payouts
In a dividendpayoutscenario, dividend distributions made by the mutual fund are paid out directly to the shareholder. If the shareholder chooses this option, dividends are usually swept directly into a cash account, transferred electronically into a bank account, or sent out by check. As is the case with the dividend reinvestment option, shareholders in most cases incur no fees for having their dividends paid in cash.
Choosing to reinvest dividends or have them paid out does not affect the tax implications of those dividends. From a tax perspective, dividend distributions are treated identically in either situation.
A shareholder can choose to skip both the growth and dividend reinvestment options and instead have the dividends paid out directly; in this scenario, the money is paid out directly to the investor.
The Bottom Line
No single mutual fund is perfect for every investor; that's why there are so many out there with so many different options. When investing in a mutual fund, it's best to examine its specific attributesto avoid investing in a fund that doesn't suit your unique requirements for growth or cash payout.
FAQs
Which option is better – growth or dividend reinvestment? The gross value of your holding in both options is usually comparable. However, growth options score in the aspect of tax efficiency, making the net value more than dividend reinvestment options in most cases.
Which is better, growth or dividend reinvestment? ›
Growth funds tend to have an advantage if your timetable is longer than dividend-focused mutual funds. This means they are more likely, but not always or even nearly so, to outpace what your dividend reinvestments would.
Which option is better growth or dividend? ›
The NAV of growth option will always be higher than the dividend option because the profits re-invested in the growth option may grow in value over time. The total returns of growth option are usually higher than dividend option over sufficiently long investment horizon due to compounding effect.
Is it better to take dividends or reinvest? ›
If you're mainly investing for long-term growth, you'll probably want to reinvest dividends. Since 1926, dividends have made up a large chunk (about 4 percentage points) of the equity market's 10% average annualized return.
What are the cons of dividend reinvestment? ›
Dividend reinvestment has some drawbacks. One downside is that investors have no control over the price at which they buy shares. If the stock gains significant value, they'd still buy shares at what could be a high price.
Should I go for dividend or growth? ›
Dividend stocks provide steady income and can act as a hedge against market volatility, while growth stocks offer the potential for substantial long-term gains. The key is to balance these approaches based on individual investment goals, risk tolerance, and time horizon.
When should you stop dividend reinvestment? ›
There are times when it makes better sense to take the cash instead of reinvesting dividends. These include when you are at or close to retirement and you need the money; when the stock or fund isn't performing well; when you want to diversify your portfolio; and when reinvesting unbalances your portfolio.
Are dividend reinvestment plans worth it? ›
For investors, particularly those with a long-term investment horizon, it could mean the difference between working until you're 70 or retiring earlier in a strong financial position. A DRP is a great tool to help investors achieve a range of investment outcomes, including: earning compounding returns.
Can I switch from dividend to growth option? ›
It is possible to switch from dividend option to growth option or vice-versa. It would entail sale of old units and purchase of new units. This might attract exit loads along with a tax on capital gains. Before you switch from one option to another, check for both of these aspects.
What is the fastest way to grow dividend income? ›
Setting Up Your Portfolio
- Diversify your holdings of good stocks. ...
- Diversify your weighting to include five to seven industries. ...
- Choose financial stability over growth. ...
- Find companies with modest payout ratios. ...
- Find companies with a long history of raising their dividends. ...
- Reinvest the dividends.
Reinvesting Dividends: Instead of taking dividend payouts in cash, Buffett reinvests these dividends to buy more stock shares or new stocks at great value prices. This is key.
Do you avoid taxes if you reinvest dividends? ›
Reinvested dividends may be treated in different ways, however. Qualified dividends get taxed as capital gains, while non-qualified dividends get taxed as ordinary income. You can avoid paying taxes on reinvested dividends in the year you earn them by holding dividend stocks in a tax-deferred retirement plan.
Should you reinvest dividends in a recession? ›
Even if the market experiences a downturn, reinvesting dividends could still yield benefits over time through the power of dollar-cost averaging. Using this strategy, you can reinvest dividends to buy additional shares when stock prices are low.
Should I turn on dividend reinvestment? ›
Long term, the biggest advantage of dividend reinvestments is the effect of automatic reinvestment on the compounding of returns. Investing your dividends into more shares of the same company increases the number of dividends you receive (since you now own more shares that pay out that dividend).
What are the disadvantages of reinvesting? ›
Risk of Overinvestment: When reinvesting profits, there's always the risk of overinvesting in your business. This could result in spending too much on expansion or marketing, negatively impacting profitability. Limited Resources: You may have limited resources if you rely solely on profits to fund your business growth.
How powerful is dividend reinvestment? ›
Critical to the long-term strategy known as dividend-growth investing, dividend reinvestment can help enhance your investment returns, build wealth over time and, with persistence and patience, generate a source of income.
What is the major advantage of dividend reinvestment programs? ›
Long term, the biggest advantage is the effect of automatic reinvestment on the compounding of returns. When dividends are increased, shareholders receive an increasing amount on each share they own, which can also purchase a larger number of shares.
What is the best dividend growth? ›
Dividend Growth Market Leaders
- XOM115.011.60% Exxon Mobil Corporation.
- JNJ156.283.93% Johnson & Johnson.
- KO65.810.85% The Coca-Cola Company.
- MCD253.37-0.68% McDonald's Corporation.
- MDT79.970.57% Medtronic plc.
- SHW332.02-12.48% The Sherwin-Williams Company.
- CTAS754.05-1.99% Cintas Corporation.
- EMR114.08-3.54%
Growth stocks typically don't pay dividends. Growth stocks are often put in contrast with value stocks.
