When a stock or fund that you own pays dividends, you can pocket the cash and use it as you would any other income, or you can reinvest the dividends to buy more shares. Having a little extra cash on hand may be appealing, but reinvesting your dividends can really pay off in the long run.
Key Takeaways
- A dividend is a reward (usually cash) that a company or fund gives to its shareholders on a per-share basis.
- You can pocket the cash or reinvest the dividends to buy more shares of the company or fund.
- With dividend reinvestment, you are buying more shares with the dividend that you’re paid, rather than pocketing the cash.
- Reinvesting can help you build wealth, but it may not be the right choice for every investor.
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The Basics ofDividends
If a company earns a profit and has excess earnings, it has three options:
- Reinvest the cash in its operations
- Pay down its debt obligations
- Pay a dividend to reward shareholders for their investments and continued support
Dividends are usually paid out quarterly, on a per-share basis. The decision to pay (or not pay) a dividend is typically made when a company finalizes its income statement, and the board of directors reviews the financials. When a company declares a dividend on the declaration date, it has a legal responsibility to pay that dividend.
Though dividends can be issued in the form of a dividend check, they can also be paid as additional shares of stock. This is known as dividend reinvestment. Either way, dividends are taxable.
You may be able to avoid paying tax on dividends if you hold the dividend-paying stock or fund in a Roth individual retirement account (IRA).
Dividends Paid on Per-Share Basis
Dividends are issued to shareholders on a per-share basis. The more shares you own, the larger the dividend payment you receive. Here’s an example: Say ABC Co. has 4 million shares of common stock outstanding. It decides to issue a dividend of 50 cents per share. In total, ABC pays out $2 million in dividends. If you own 100 shares of ABC stock, your dividend will be $50. If you own 1,000 shares, it will be $500.
What Is Dividend Reinvestment?
If you reinvest dividends, you buy additional shares with the dividend rather than take the cash. Dividend reinvestment can be a good strategy because it is:
- Cheap: Reinvestment is automatic—you won’t owe any commissions or other brokerage fees when you buy more shares.
- Easy: When you set it up, dividend reinvestment is automatic.
- Flexible: Though most brokers won’t let you buy fractional shares, you can with dividend reinvestments.
- Consistent: You buy shares on a regular basis—every time you get a dividend. This is dollar-cost averaging (DCA) in action.
If you reinvest dividends, you can supercharge your long-term returns because of the power of compounding. Your dividends buy more shares, which increases your dividend the next time, which lets you buy even more shares, and so on.
Dividend Reinvestment Plans
You can reinvest the dividends yourself. However, many companies offer dividend reinvestment plans (DRIPs) that simplify the process. DRIPs automatically buy more shares on your behalf with your dividends. There are several benefits to using DRIPs, including:
- Discounted share prices
- Commission-free transactions
- Fractional shares
One of the chief benefits of dividend reinvestment lies in its ability to grow your wealth quietly and steadily. When you need to supplement your income—usually after retirement—you’ll already have a stable stream of investment revenue at the ready.
Example of Reinvestment Growth
Say ABC Co. pays a modest dividend of 50 cents per share. To keep things simple, we’ll assume the stock price increases by 10% each year and the dividend rate moves up by 5 cents each year.
You invest $20,000 when the stock price is $20, so you end up with 1,000 shares. At the end of the first year, you receive a dividend payment of 50 cents per share, which comes out to $500 (1,000 × $0.50).
The stock price is now $22, so your reinvested dividend buys an extra 22.73 shares ($500 / $22). Though you can’t buy fractional shares on the open market, they’re common in DRIPs.
At the end of the second year, you earn a dividend of 55 cents per share. This time, it’s on 1,022.73 shares, so your total dividend payment is $562.50 (1,022.73 × $0.55). The stock price is now $24.20, so reinvesting this dividend buys another 23.24 shares ($562.50 / $24.20). You now own 1,045.97 shares, valued at $25,312.47.
Three years after your initial investment, you get a dividend of 60 cents per share, which comes out to $627.58 (1,045.97 × $0.60). Because the stock price has risen to $26.62, the dividend buys another 23.58 shares.
At the end of just three years of stock ownership, your investment has grown from 1,000 shares to 1,069.55 shares. And due to the stock’s gains, the value of your investment has grown from $20,000 to $28,471.
As long as a company continues to thrive and your portfolio is well balanced, reinvesting dividends will benefit you more than taking the cash will. But when a company is struggling or when your portfolio becomes unbalanced, taking the cash and investing the money elsewhere may make more sense.
Cash vs. Reinvested Dividends
Assume ABC’s stock performs consistently and the company continues to raise its dividend rate the same amount each year (keep in mind, this is a hypothetical example).
After 20 years, you would own 1,401.25 shares valued at $188,664.30, and your dividend would be $2,031.82.
If you had taken your dividend payments in cash instead of reinvesting them, you would have pocketed $24,367.68 in dividends. But you would have just 1,000 shares now, worth only $134,640. By reinvesting your dividends each year, you increased your gains by 47%.
When to Take the Cash
Still, despite the obvious benefits of dividend reinvestment, there are times when it doesn’t make sense, such as when:
- You’re at or near retirement, and you need the income. Consider your other sources of income first—Social Security, required minimum distributions (RMDs) from retirement accounts, pensions, annuities—before deciding if you need the dividend income. If you don’t need it, then you can keep reinvesting and growing your investment.
- The underlying asset is performing poorly. All stocks and funds experience price swings, so it can be difficult to know if it’s time to switch gears. Still, if the stock or fund seems like it has stalled, then you might want to pocket the dividends. Of course, if the investment is no longer providing value—or if it stops paying a dividend—then it may be time to sell the shares and move on.
- You want to diversify. By taking dividends in cash instead of reinvesting them, you candiversify into other assets,rather than adding to a position that you already have.
- It throws your portfolio out of balance. Higher-yielding, faster-growing securities have a way of building up far quicker than other assets do. That means it could just be a matter of time before you’re overweight in a few investments. When these securities perform well, it’s a plus. But when they don’t, the losses will be that much greater.
What Are the Benefits of Reinvesting Dividends?
The primary reason to reinvest your dividends is that doing so allows you to buy more shares and build wealth over time. If you examine your returns 10 or 20 years later, reinvesting is more likely to increase the value of your investment than simply taking the cash. Also, reinvesting allows you to purchase fractional shares and get discounted prices.
When Should You Not Reinvest Dividends?
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. In the last case, if you are overweighted in just a handful of investments and the securities don’t perform well, then you stand to lose more than if your portfolio is more balanced.
What Are DRIPs?
DRIPs are dividend reinvestment plans. Companies often have DRIPs, which automatically reinvest dividends by buying more shares for an investor. When you rely on a DRIP, there are no commissions or brokerage fees for the shares that you buy, you can get discounted share prices, and you can buy fractional shares, which brokers usually don’t allow. DRIPs can make reinvesting your dividends easy, cheap, and consistent.
The Bottom Line
One of the key benefits of dividend reinvestment is that your investment can grow faster than if you pocket your dividends and rely solely on capital gains to generate wealth. It’s also inexpensive, easy, and flexible.
Still, dividend reinvestment isn’t automatically the right choice for every investor. It’s a good idea to chat with a trusted financial advisor if you have any questions or concerns about reinvesting your dividends.
