When a company has excess earnings, it can reinvest the cash, pay down debt, or share the profits with shareholders by paying a dividend. Dividends reward shareholders for their investments and are usually paid quarterly on a per-share basis. For example, if a company pays a $2 dividend and you own 100 shares, you will receive a $200 dividend. If you own 1,000 shares, your dividend will be $2,000.
When you own a dividend-paying stock, you can receive the dividends in cash or reinvest them. Cash dividends provide immediate income you can spend, save, or invest however you choose. Reinvestment lets you accumulate more shares of the same company over time, leading to higher potential long-term returns. Here are the pros and cons of dividend reinvestment to help you decide if this wealth-building strategy is right for you.
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How does dividend reinvestment work?
When you elect to reinvest your dividends, the money from the dividend payment is used to buy additional shares of the same dividend-paying stock. Each dividend you receive buys a different number of shares due to varying dividend payments and share prices. For example, if you receive a $1 dividend on a $50 stock, the dividend reinvestment would buy 0.02 (1 ÷ 50) shares for each share you own. A $2 dividend on a $20 stock would buy 0.10 (2 ÷ 20) shares.
Many companies offer dividend reinvestment plans ( DRIPs), which automatically use your dividends proceeds to buy more company shares. DRIPs offer several benefits, including discounted share prices, commission-free transactions, and fractional share purchases. You can also reinvest your dividends through your broker by enrolling in its DRIP program or manually placing a buy order for the desired number of shares when you receive a cash payout.
What happens when you don't reinvest dividends?
When you choose not to reinvest your dividends, you receive a cash payout instead. This can make sense if you want more control over your investment decisions or income to spend, save, or invest elsewhere. The downside is that pocketing the cash means you won't benefit from the power of compounding and potential long-term growth.
What happens when you do reinvest dividends?
When you reinvest your dividends, the money you earn from those dividends goes toward buying more shares. This strategy lets you compound your gains to build wealth over time. However, you miss out on potential cash flow you could put to work elsewhere—whether to fill an immediate financial need or diversify into other assets.
Dividend reinvestment pros and cons
Dividend reinvestment can be a sound investment strategy. Still, it's essential to consider the pros and cons before picking dividend reinvestment versus a cash payout.
Pros
- You are compounding earnings. One of the most significant advantages of dividend reinvestment is that it allows you to buy more shares and build wealth over time. As you reinvest your dividends, the investment grows, and you earn even more dividends—and so on.
- You can lower risk through dollar-cost averaging. You can take advantage of dollar-cost averaging by reinvesting over time in equal portions at regular intervals, limiting the inherent risks of timing the market.
- It's easy and convenient. Once you register with the company's DRIP or set up your brokerage account to reinvest your dividends, the process is automatic and continues until you opt out.
- There are no trading fees. Dividend reinvestment through the company's DRIP or your broker's program is usually commission free.
- You can score DRIP discounts. Some companies offer discounts of 1% to 5% off the recent stock price when you reinvest dividends through a DRIP.
Cons
- It can limit diversification. When you reinvest your dividends in a company you already own, your portfolio can become unbalanced.
- There may be share minimums. Some companies have minimum share requirements to participate in a DRIP.
- Your cash is tied up. By reinvesting your dividends, you miss out on cash you could spend, save, or invest elsewhere.
- You might still owe taxes. Dividends are taxed whether you take a cash payout or reinvest them. However, with no cash payout, you have to pay the tax bill out of pocket.
- It's easy to neglect. You might stick with a dividend reinvestment strategy because it's easy and convenient—even if your investment goals have changed.
Considerations before reinvesting dividends
When deciding whether or not to reinvest dividends, it's helpful to consider the following factors:
- Your investment goals. If your goal is long-term portfolio growth, dividend reinvestment makes sense: Reinvested dividends help grow your investment. If you aim to generate an income stream or fund an immediate financial need, you're better off taking cash dividends.
- Your investment style. If you're a buy-and-hold investor, you might want to reinvest dividends to increase your position size and potentially enjoy larger profits down the road when you sell. Active traders may prefer cash dividends to boost their trading accounts.
- Your time horizon. Reinvested dividends need time to compound. You might be better off taking cash dividend payouts if you have a short time horizon. Reinvestment makes more sense if you have time to let compounding do its magic.
- Market conditions. Stock prices rise during bull markets, so you might benefit from reinvesting your dividends. On the other hand, many investors prefer to keep more of their money in cash during bear markets.
- The type of IRA you have. Traditional IRAs are tax deferred, meaning you'll pay taxes on your dividends eventually. You can avoid taxes by holding your dividend-paying stocks in a Roth IRA and taking qualified distributions in retirement, which aren’t taxable.
How do you reinvest dividends?
When you reinvest your dividends, you buy additional shares with the dividend instead of pocketing the cash. There are three primary ways to reinvest dividends:
- Participate in the company's DRIP. Many companies offer DRIPs to automatically buy more shares with your dividends. It's a commission-free transaction, and some companies even offer DRIP shares at a discounted price.
- Reinvest through your brokerage account. Most online brokers offer a no-fee, no-commission DRIP. To enroll, change your preferences in the "dividends" section of your broker's settings page—generally no later than the day before the ex-dividend date. Many robo-advisors, including M1 Finance, also offer automatic dividend reinvestment.
- Manually reinvest your dividends. With this approach you use a cash dividend to buy additional investment shares via your broker. You might opt for this if you want more control over your investments or your broker doesn't offer a DRIP (for example, TradeStation is a robust trading platform, but you'll have to reinvest your dividends by hand).
Stocks aren't the only investment that offers dividend reinvestment. For example, you can also reinvest dividends from exchange-traded funds (ETFs), mutual funds, and American depository receipts (ADRs).
Dividend reinvestment growth example
Dividend reinvestment can help you grow your investment portfolio over time. Here's an example. Say you buy $20,000 of XYZ stock at $20 per share, so you have 1,000 shares. The company pays a dividend of $2 per share, which increases by $0.25 a year, and the share price goes up 10% yearly.
At the end of the first year you receive a $2,000 dividend ($2 dividend X 1,000 shares). The stock price has increased by 10% to $22, so your reinvested dividend buys 90.91 more shares. You now own a total of 1,090.91 shares worth $24,000.02.
At the end of the second year the company pays a per-share dividend of $2.25. Because you reinvested your dividends the previous year, the dividend is based on 1,090.91 shares. Your dividend is $2,454.55 ($2.25 dividend X 1,090.91 shares). The stock price has increased to $24.20, so reinvesting buys another 101.43 shares. You now own 1,192.34 shares valued at $28,854.63.
At the end of the third year the company pays a dividend of $2.50 per share, totaling $2,980.85 ($2.50 dividend X 1,192.34 shares). Because the stock price has increased to $26.62, the dividend buys another 111.98 shares. You now own 1,304.32 shares valued at $34,721.
After just three years your original 1,000-share investment has grown to 1,304 shares. And due to the stock's gains and your additional shares, the value has grown from $20,000 to $34,721—a 73% increase.
Of course, not all dividend-paying stocks have the same growth potential. The gains you enjoy depend on the company's dividends, share prices, the number of shares you own, and how long you hold the investment.
DRIP investing: Dividend reinvestment plans
A DRIP takes your dividend and uses it to buy shares automatically. As a result of compounding, you grow your position over time with little to no effort: You acquire more shares with each dividend, which can lead to a larger dividend next time—and so on. You can enroll in a DRIP directly through the issuing company or your broker.
One of the primary benefits of dividend reinvestment is its ability to grow your wealth quietly and steadily if the stocks do well. When you need extra income—usually during retirement—you'll have a stable stream of investment revenue at the ready.
TIME Stamp: Cash vs. dividend reinvestment: Know when to take the cash
Dividend reinvestment can be part of a long-term wealth-building strategy. As you reinvest your dividends, your investment grows, resulting in even more dividends—and more shares. This creates a snowball effect that can help you build wealth with little effort over the long term.
Despite the benefits of dividend reinvestment, it's not the best choice for every investor. You might want to take the cash instead if:
- You're at (or near) retirement and need the income. Tally your retirement income sources—Social Security, required minimum distributions (RMDs), pensions, annuities, reverse mortgages, and the like—before deciding if you need the dividend income. If you come up short, you might want to take your dividends in cash. Otherwise, consider reinvesting to continue growing your investment.
- You need the cash to reach a goal. It might make sense to pocket the cash to pay off debt, fund a home improvement, or cover another considerable expense—especially if the alternative is racking up credit card debt or taking out a high-interest loan.
- You want to diversify. Taking dividends in cash lets you diversify into other assets instead of adding to an existing position, which can mitigate volatility and risk in your portfolio.
Of course, weighing the pros and cons before deciding to reinvest your dividends or pocket the cash is essential. As with any investment decision, it's a good idea to consult with your broker or financial advisor (such as someone you found through WiserAdvisor). You'll explore the pros and cons of each option and determine which approach aligns best with your risk tolerance and financial goals.
Frequently asked questions (FAQs)
How do I reinvest dividends if the dividend isn't enough to buy a whole share?
DRIPs generally allow you to reinvest dividends of any amount, even if it only buys a fractional share. For example, if you get a $10 dividend and a share costs $20, you can reinvest the $10 to buy 0.50 shares.
How do I stop reinvesting dividends?
If you want to switch to cash dividends, notify the issuing company that you no longer want to participate in its DRIP. If you set up the DRIP through your broker, you can change your preferences in the "dividends" section of your broker's settings page.
What are DRIPs?
When you own a dividend-paying stock, the issuing company may offer a dividend reinvestment plan (DRIP), which automatically reinvests your dividends at no extra cost. Some companies offer discounts on DRIP shares, giving you a better price than you could get on the open market. Many brokers and robo-advisors also offer DRIP programs to reinvest dividends on your behalf.
When should you not reinvest dividends?
Taking a cash dividend can be a better option when you're at or near retirement and need the income—or want to diversify your portfolio instead of adding to an existing position. When in doubt, talk with your financial advisor to determine the best option for your financial goals.
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