What Is a Distribution Reinvestment?
Distribution reinvestment is a process whereby the distribution from a pooled investment trust is automatically reinvested in the trust. Dividend reinvestment plans (DRIPs) are a common form of distribution reinvestment. Distributions from limited partnerships like real estate investment trusts (REITs) or other pooled investments are also often reinvested into common units or shares in the fund, often at a discount to the current market price.
Investors can set up distribution reinvestment plans with the partnership itself, or with a broker through which the units are held.
- Distribution reinvestment occurs when distributions from a pooled investment fund are used to purchase additional investments in the fund.
- Distributions may come in the form of dividends, interest, capital gains, and so on.
- Pooled funds that may have distribution reinvestment include mutual funds, ETFs, REITs, and investment trusts.
- Distributions are usually taxable events, even if they are reinvested and not taken as cash.
- Dividend reinvestment plans (DRIPs) are a common type of distribution reinvestment.
Understanding Distribution Reinvestments
A distribution from an investment refers to a payment in cash or return of principal in some form. These include dividends, interest payments, realized capital gains, rents, royalties, and so on. Individual stocks may feature dividend reinvestment plans (also called DRIPs), which allow investors to automatically use dividends received to purchase additional shares in that company.
Mutual funds and other pooled investments make distributions as holdings with the fund's portfolio pay out dividends or interest, or when the fund sells a position for a gain. Most fund distributions are recorded quarterly, but some may occur on a monthly basis. Reinvestment occurs when the portfolio manager uses these distributions to add to the investments within the fund.
Distribution Reinvestment Real Estate Investment Trusts (REITs)
A real estate investment trust is a company that owns – and typically operates – income-producing real estate or real estate-related assets. REITs provide a way for individual investors to earn a share of the income produced through commercial real estate ownership without actually having to go out and buy commercial real estate. Income-producing real estate assets include office buildings, shopping malls, apartments, hotels, resorts, self-storage facilities, warehouses, and mortgages or loans.
What distinguishes real estate investment trusts from other real estate companies is that a REIT must acquire and develop its properties primarily to operate them as part of its own investment portfolio, as opposed to reselling those properties after they have been developed.
To qualify as a real estate investment trust, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90% of its taxable income to shareholders annually in the form of dividends.
Mutual Fund Distributions
Mutual funds are required by law to payout portfolio earnings to investors. Interest and dividends earned on a fund's portfolio become dividend payments to fund investors. If portfolio holdings are sold for a profit, the net profits become an annual capital gains distribution. Mutual funds are required by law to make regular capital gains distributions to their shareholders as they sell holdings for net profits.
The option to reinvest dividends automatically is a benefit of mutual fund investing. Mutual funds are one of the few types of investments where earnings can be reinvested to compound and grow. Dividends and capital gains are reinvested at no cost.
Even if a mutual fund ends up losing money in a given year (i.e. has a negative net return), if certain holdings within the fund were sold and distributed as capital gains, fund shareholders would be required to pay taxes on those distributions.
Advantages and Disadvantages of Distribution Reinvestment
Distribution reinvestment is a good way to grow positions organically and take advantage of the power of compounding. This helps accelerate future gains as new distributions are credited not only to the initial investment but also to the reinvested amounts.
Investors who participate in distribution reinvestment programs also generally are waived of commissions and other fees, making it an advantageous and affordable way to grow their investment over time. Meanwhile, financial managers have a stable way to grow assets with current investors.
The main disadvantage of distributions is that they are taxable events, even when reinvested. This means that funds or other investments that generate a lot of frequent distributions can be less tax efficient for investors. One solution is to keep investments with large or frequent distributions in tax-advantaged accounts such as a Roth IRA.
A second disadvantage of distribution reinvestment is that it may not be appropriate for certain investors who need income from their investments. In such a case, it would be better to take distributions as cash and not reinvest it.
Pros and Cons of Distribution Reinvestment
Grow investments organically
Cost-effective approach to compounding
Keeps portfolios stable for fund managers
Not appropriate if investor needs cash flows
Example of Distribution Reinvestment
The Vanguard 500 Index Fund (VFIAX) seeks to duplicate the performance of the S&P 500. It disburses dividend distributions quarterly (in March, June, September, and December).
For 2021, investors received $5.44 for every share of the fund they owned. Unless a customer specifies otherwise, Fidelity automatically reinvests these distributions, increasing the number of shares of the fund owned. 2021 distributions were reinvested at an average share price of $395.
Are Reinvested Distributions Taxable?
Yes. Distributions are considered taxable by the IRS even if they are reinvested instead of taken in cash.
What Does Reinvesting Capital Gains Mean?
When a mutual fund or other managed portfolio sells shares, it will typically use those proceeds to purchase different investments. While this is common in actively managed portfolios, a passive fund would also see capital gains reinvested when the portfolio is rebalanced. For instance, if an 80%/20% stocks to bonds portfolio see stocks rise significantly, the allocation weight may drift to 85% stocks and 15% bonds. The rebalancing would require stocks to be sold for capital gains in order to purchase bonds so that the 80/20 mix is restored.
What Is Reinvestment Risk?
Reinvestment risk usually applies to investing in fixed-income securities such as bonds. This is the risk that cash flows received from such a security would be reinvested in a new security with a lower yield or rate of return than the initial investment.