There are several good reasons to reinvest mutual fund dividends. It's a great way to build wealth on autopilot. Money that never makes its way into your hand is less tempting to spend, just like 401(k) retirement deductions from your paycheck never get a chance to become spending money. Reinvested dividends buy more fund shares and increase your principal. This generates more dividends over the years, tapping the power of compounding returns without requiring you to lift a finger.
Reinvesting mutual fund dividends helps offset dips in the market. Since the reinvestments are made in good times as well as bad, some dividends will inevitably come at times when the fund value is down. If the fund share price falls from $100 to $83, and your dividend is $1,000, you get 12 new shares instead of 10 shares. When the fund rebounds to $100 a share, you have 12 shares that grew by $17 apiece.
If you are investing in a mutual fund with a front-end load, you typically avoid the buy-in fee when you are reinvesting your dividends. So if you normally pay, for example, 3% of every monthly contribution, the dividend is a free boost to your savings. Be sure, however, to verify this with your broker.
When Not to Reinvest
Retirees and others who need to live off their investments can opt to get the dividends from their mutual funds paid in cash.
There's also the option of taking cash dividends from your mutual funds to invest elsewhere. This can be part of a diversification strategy since reinvesting the dividend back into the same mutual funds means that you're keeping a growing pile of eggs in the same basket. If that basket starts to feel a little too risky, it may be prudent to use the dividends to create secondary safe harbor investments. On the flip side of that coin, an active investor may see better investments elsewhere and consider the dividends to be found money for more daring endeavors.
Taxes and Broker Account Settings
Dividends from mutual funds in non-retirement accounts are subject to capital gains tax, regardless of whether you reinvest or take a cash payout. Keep good records and consult with your tax preparer if you're unsure about your situation. You must report tax-free funds, such as municipal bond funds, on your tax return even if you don't owe any taxes.
If you decide to reinvest your dividends, double-check your broker account settings. Sometimes the default is not to buy shares in the same fund, but to have it directed to a safe money market fund. Since these get virtually zero return these days, but they still have annual fees, you're guaranteed to get a negative real return.