There’s no such thing in the world as free money, but investment dividends come close.
Along your investing journey, you’ll likely see activity categorized as dividends in your accounts. Dividends are payments passed back to investors, usually when a company posts a profit. Stocks and funds can both pay dividends, and the amount and frequency of dividends paid can vary by company or fund.
Dividends are considered income, so it’s up to you to choose what to do with that income. Many people choose to use the money to reinvest in the same companies or funds, while others opt to take the cash. While taking the cash can make sense for those in the later stages of their investing journey, experts say that reinvesting your dividends and tapping into the magic of compound growth is the better move for most investors.
Here’s what to know about dividend reinvestment and how to use it to grow your wealth.
What Is Dividend Reinvestment and How Does It Work?
When companies make more earnings than their expenses, they can reinvest the extra money in their own company — or pass it to the shareholders as a dividend to share the profits, explains Gina Sanchez, chief market strategist at Lido Advisors, an LA-based investment consultancy. You can think of dividends as a way companies reward long-term shareholders for owning their stock.
Not every company offers a dividend. Some companies choose to reinvest their profits into research and development to grow their business and raise the stock price, whereas others share their profits as dividends with investors. Companies with a proven track record of increasing dividend payouts to investors every year are known as Dividend Kings and Dividend Aristocrats.
When a dividend-paying stock or fund declares a dividend, it’s paid out to shareholders, usually as cash but occasionally as additional shares of stock. Dividend reinvestment plans, also referred to as DRIPs, are an arrangement that allow shareholders of certain securities to use their dividends to purchase additional whole or fractional shares of a stock, ETF, or mutual fund for no added cost.
If you’ve chosen to reinvest your dividends, the cash will be used to purchase additional shares of the underlying investment, which increases your holdings in the company or fund.
Reinvesting dividends puts your money to work for you, explains Sachin Jhangiani, co-founder and CMO of Elevate.Money, a real estate investing platform. “You’re making income on your income — and that’s the power of compounding,” he says.
You can also choose to take the cash to spend whatever you want, like to cover your living expenses. Or, if you want to limit your exposure to a particular company or fund, you can take the dividend as cash and use the money to buy other investments to diversify your portfolio further.
Should You Reinvest or Take the Cash?
Whether you should reinvest dividends or take the cash depends on two main factors: whether you want to add more of the same stock or fund to your portfolio, and where you are in your investment timeline.
While it might be tempting to take the cash, reinvesting might benefit you more in the long run, especially if you’re receiving regular dividend payments from profitable investments. If you have a long investment timeline or don’t need additional income, experts recommend reinvesting your dividends by acquiring more shares of stock. That way, the money you earned is used to earn even more money for you in the future.
But if you’re retired or need supplemental income, dividends can be a valuable supplemental income source. In fact, many retirees use their dividends for everyday living expenses.
If you’re in the accumulation phase where you’re saving for retirement while working, you don’t need the income from dividends so you’ll likely want to reinvest it, says Sanchez. Once you reach retirement, you’ll enter your distribution phase and start taking money out of your portfolio to maintain your lifestyle. At that point, you may lean toward taking the income from dividends rather than reinvesting it, if it’s a part of your income needs.
Ultimately, the best answer for you will depend on where you are on your investment journey.
How to Reinvest Dividends
Most brokerage accounts have settings that allow you to enroll in automatic DRIP plans. Once you find the reinvestment options, you should see the following choices:
- Reinvest all current and future stocks and funds
- Reinvest all current stocks and funds
- Reinvest select stocks and funds
When you enroll in a DRIP plan, you get an automated, set-it-and-forget-it experience. When a company or fund posts a dividend, your brokerage will purchase more of the asset on your behalf and add it to your account. These purchases are usually commission-free, and all the cash will be used to buy more of the same underlying fund. If the dividend amount isn’t enough to purchase a full share of the stock or fund, most brokerages will allow you to purchase fractional shares. All of this typically happens within a few days of receiving a dividend.
Keep in mind that most employer-sponsored retirement accounts and some IRAs will automatically reinvest your dividends by default. If you’re unsure about your enrollment status, be sure to check your account settings or reach out to a financial professional that can help you with your account.
When you’re saving for retirement, you’ll most likely want to reinvest your dividends to keep your money working for you. There are few instances where taking the cash is favorable when you’re in your accumulation phase.
If you don’t want an automatic dividend reinvestment plan, you can choose to receive cash and then use the cash to purchase more of the same stocks or funds. Some investors will save their cash and buy more securities when the market dips, though trying to time the market isn’t necessary for long-term index fund investors. Others might take profits from income stocks to buy growth stocks. Or you could get the cash and buy another stock or fund for more diversification in your overall portfolio.
Tax Implications With Dividend Reinvestment
Any time there’s income, the government wants its share of taxes. Dividends are no exception.
“Whether you reinvest the dividend or take the cash, your tax implications are the same,” says Harold Hofer, co-founder and CEO of Elevate.Money. While reinvesting dividends doesn’t have any special tax advantages, doing so will still benefit from being taxed at the lower long-term capital gains rate. Dividends received as stock are usually taxed when the stock is sold.
Qualified dividends, which are those held for a certain length of time in domestic corporations, are taxed at the long-term capital gains rates of 0%, 15%, or 20%, depending on your tax bracket.
Non-qualified, or ordinary, dividends are those that don’t meet the IRS criteria for special tax treatment, and include dividends from real estate investment trusts (REITs), master limited partnerships (MLPs), foreign corporations, and special one-time dividend payments. These dividends are taxed as ordinary income.
With most retirement accounts and traditional IRAs, you’ll pay taxes when you withdraw (after you’re 59 ½) at whatever your current income tax rate is at the time. The exception is Roth IRAs, where you invest with after-tax dollars but your investments, including dividends, grow tax-free. That’s one of the many reasons to choose a Roth IRA when you’re a young investor.