The Benefits of Reinvesting Dividends: A Complete Guide

When a company has extra money, it can either reinvest it, pay off debt, or share it with shareholders through dividends. Dividends are a way to reward shareholders and are paid quarterly per share. If you own a stock that pays dividends, you can get the dividends in cash or choose to reinvest them. Cash dividends give you money you can use immediately, save, or invest however you like. Reinvesting lets you buy more shares of the same company, which can lead to more significant returns over time. Here's a look at the pros and cons of reinvesting dividends to help you figure out if this strategy is for you.

The Functioning of Dividend Reinvestments

When you choose to reinvest your dividends, the money from the dividend is used to buy more shares of the same stock. The number of shares you get can vary because of different dividend amounts and share prices.  Many companies have dividend reinvestment plans (DRIPs) that automatically use your dividends to buy more shares. DRIPs can offer perks like discounted share prices, no commission fees, and the ability to buy fractional shares. You can also reinvest dividends through your broker by signing up for their DRIP program or by placing a buy order when you get a cash payout.

When you reinvest dividends, the money you make goes toward buying more shares. This helps you compound your gains and build wealth over time. However, you might miss out on cash flow that you could use for other things, like immediate financial needs or diversifying your investments. If you decide not to reinvest your dividends, you get the payout in cash. This can be a good idea if you want more control over your investments or need the cash for other purposes. The downside is that taking the cash means you won't benefit from compounding and potential long-term growth.

Dividend Reinvestment vs. Cash

Dividend reinvestment can be a solid part of a long-term wealth-building game plan. By reinvesting your dividends, your investment keeps growing, leading to more dividends and more shares, creating a snowball effect that can help build wealth with minimal effort over time. But, dividend reinvestment isn't for everyone. You might want to take the cash instead if:

You want to diversify

Cash dividends let you spread your investment into other assets, reducing volatility and risk in your portfolio.

You need the cash for a goal

Using the cash to pay off debt, fund home improvements, or handle big expenses might make more sense, especially if it keeps you from racking up credit card debt or taking out high-interest loans.

You're at (or near) retirement and need the income

Check your retirement income sources Social Security, RMDs, pensions, annuities, reverse mortgages, etc. before deciding. If you need more income, taking dividends in cash could help. Otherwise, reinvesting might be better to keep growing your investment.

Always weigh the pros and cons before reinvesting dividends or taking the cash. Talking to your broker or financial advisor (like someone from Wiser Advisor) can help you determine which option best fits your risk tolerance and financial goals.

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Enrolling in DRIP Investing

A DRIP (Dividend Reinvestment Plan) automatically uses your dividend to buy more shares. Thanks to compounding, your position grows over time with hardly any effort: more shares mean more enormous dividends next time, and so on. Sign up for a DRIP through the issuing company or your broker. The main perk of dividend reinvestment is its ability to grow your wealth steadily if the stocks perform well. When you need extra income usually in retirement you'll have a steady stream of investment revenue ready to go.

Process of Reinvesting Dividends

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So, when you reinvest your dividends, you're buying more shares with the money you get instead of just taking the cash. Here are three main ways to do it:

You can reinvest manually

If you want more control or if your broker doesn't offer a DRIP (like Trade Station), you can use the cash dividend to buy more shares yourself.

Utilize your brokerage account

Most online brokers have a no-fee, no-commission DRIP option. Go to the "dividends" section in your broker's settings and change your preferences before the ex-dividend date. Many robo-advisors, like M1 Finance, also offer automatic dividend reinvestment.

Join your firm's DRIP

Many companies have these Dividend Reinvestment Plans (DRIPs) that let you automatically buy more shares with your dividends. It's usually commission-free, and sometimes you even get a discount on the shares. It's not just stocks you can reinvest dividends from ETFs, mutual funds, and ADRs.

Things to Think About Before Reinvesting Dividends

Image Source: Share Sight

Before you decide to reinvest, consider these factors:

• Your IRA account: Traditional IRAs are tax-deferred, so you'll pay taxes on dividends eventually. With a Roth IRA, you can avoid taxes on qualified distributions in retirement.
• Prevalent Market conditions: In a bull market, reinvesting could be beneficial. But you might want to keep more cash on hand in a bear market.
• The period: Reinvested dividends need time to compound. If you need the money soon, taking the cash might be more competent. If you have time, let compounding work its magic.
• The investment style: If you're a buy-and-hold type, reinvesting can help you increase your position size and potentially make more when you sell later. Active traders might prefer cash to boost their trading accounts.
• The various investment goals: Reinvesting makes sense if you're in it for long-term growth because it helps grow your investment. But if you need income or have immediate financial needs, taking the cash might be better.

The Ups and Downs of Dividend Reinvestment

Dividend reinvestment can be a solid move, but you must weigh the pros and cons before deciding whether to reinvest or take a cash payout.

The Good Stuff

• You can snag DRIP discounts: Some companies give you 1% to 5% off the recent stock price when you reinvest through a DRIP.
• No trading fees: Usually, reinvesting dividends through a DRIP or your broker's program is commission-free.
• Super easy and convenient: Once you're set-up, the process is automatic until you decide to stop.
• Lower risk with dollar-cost averaging: By reinvesting in equal amounts over time, you can dodge some risks of trying to time the market.
• Compounding earnings: Reinvesting dividends means buying more shares and growing wealth over time. It's like a snowball effect.

The Not-So-Good Stuff

• Limits diversification: Reinvesting in the same company can unbalance your portfolio.
• Share minimums: Some companies require a minimum number of shares to participate in a DRIP.
• Tied-up cash: Reinvesting means you miss out on cash you could use elsewhere.
• Taxes still apply: Dividends are taxed whether you take cash or reinvest, and without a cash payout, you'll need to cover the tax bill yourself.
• Easy to overlook: You might stick with it just because it's simple, even if your goals change.

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Conclusion

Dividend reinvestment is an intelligent way to grow your wealth steadily. Many brokers and companies make it easy to automate, letting you buy more shares (even fractional ones) with each payment and compounding your returns over time.

Frequently Asked Questions

When should dividends not be reinvested?

If you're close to retirement and need the money or want to diversify instead of adding more to what you already have, taking a cash dividend might be better. When in doubt, chat with your financial advisor to determine what's best for your goals.

How do you stop the process of reinvesting dividends?

If you want to switch to cash dividends, just let the company know you no longer want to be in their DRIP. If you set it up through your broker, you can change it in their settings' "dividends" section.

How can dividends be reinvested if they are not enough to buy a whole share?

Most DRIPs let you reinvest any amount, even if it only buys part of a share. So, if you get a $20 dividend and a share costs $10, you can use that $20 to buy 2 shares, no problem.

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