When a stock or fund 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.
Though having a little extra cash on hand may be appealing, reinvesting your dividends can really pay off in the long run.
- 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 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.
The Basics of Dividends
If a company earns a profit and has excess earnings, it has three options. It can:
Dividends are usually paid out quarterly, on a per-share basis. The decision to pay a dividend (or not) is typically made when a company finalizes its income statement, and the board of directors reviews the financials. Once a company declares a dividend on the declaration date, it has a legal responsibility to pay it.
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 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 company ABC has 4 million shares of common stock outstanding. They decide to issue a $0.50 per-share dividend. 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 reinvestment dividends, you buy additional shares with the dividend, rather than take the cash. Dividend reinvestment can be a good strategy because it's:
- Cheap. Because reinvestment is automatic, you won't owe any commissions or other brokerage fees when you buy more shares.
- Easy. Once you set it up, dividend reinvestment is automatic.
- Flexible. While 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 in motion.
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 that simplify the process. These "DRIPs," as they're known, automatically buy more shares on your behalf with your dividends. There are several benefits of 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. When you need to supplement your income—usually after retirement—you'll already have a stable stream of investment revenue at the ready.
Reinvestment Growth Example
Say company ABC pays a modest dividend rate of $0.50 per share. To keep things simple, we'll assume the stock price increases by 10% each year and the dividend rate moves up by $0.05 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 $0.50 per share, which comes out to $500 (1,000 × $0.50).
The stock price is now $22.00, so your reinvested dividend buys an extra 22.73 shares ($500 ÷ $22.00). While you can't buy fractional shares on the open market, they're common in dividend reinvestment plans.
At the end of the second year, you earn a $0.55 per-share dividend. 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 $0.60 dividend, which comes out to $627.58 (1,045.97 × $0.60). Since 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, 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 1,638.62 shares valued at $220,476, and your dividend would be $2,375.99.
If you had taken your dividend payments in cash instead of reinvesting them, you would have pocketed $31,501 in dividends. But you'd have just 1,000 shares now, worth only $166,051. By reinvesting your dividends each year, you increased your gains by 133%.
Should You Reinvest Dividends?
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, RMDs from your retirement accounts, pensions, annuities—before deciding if you need the dividend income. If not, 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, you might want to pocket the dividends. Of course, if the investment is no longer providing value—or if it stops paying a dividend—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 can diversify into other assets rather than adding to a position 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. 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 if they don't, the losses will be that much greater.
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 trust financial advisor if you have any questions or concerns about reinvesting your dividends.