Posted by The TaxAdvocate Group, LLC

Dividend Reinvestment

Dividend Reinvestment

This is a guide to help you decide if dividend reinvestment is right for you. Investors who own dividend-paying assets face the question of what to do with that money. You have several options:

  • Invest: Combine the dividend with other payments or sources of money to buy shares of another company or fund.

  • Reinvest it: Use the money to buy multiple stocks of the same company.

  • Save: Save money to fund a future expense.

  • Spend: Use the money to supplement your income.

Here's an overview of the reinvestment strategy to help you determine if it's right for you.

What is dividend reinvestment?

This uses the cash dividend paid by a company or fund to buy multiple stocks of the same investment. Any investor can use this strategy. Most brokerage accounts have automated dividend reinvestment programs that automate the purchase of new stocks of the same security, same traded fund (ETF), or mutual fund. Many dividend payers also offer investors the option of participating in a dividend reinvestment plan (also known as DRIP). In the meantime, even if a broker or company does not offer an automatic dividend reinvestment plan, the investor can manually reinvest their payments.


How does dividend reinvestment work?

Reinvesting dividends is a simple process. When a company pays out dividends, the broker or firm uses that money to buy more shares of the underlying investment, which is fully automated if an investor signs up for an automatic dividend reinvestment program or DRIP. As a result, rather than receiving cash payment, an investor will get more company shares or funds at the current market rate. If the dividend payment is less than the total cost of the shares, an investor will receive fractional shares. In addition, these purchase transactions are generally commission-free.

This is an example to help investors understand how dividend reinvestment works. An investor owns 1000 shares in a company that pays a quarterly dividend of $1. Therefore, he receives $1000 in several shares. If the shares are trading at $250 each at the time of dividend payment, that investor will own 1040 shares.

In the next quarter, the same investor will receive $1040 in dividends. If the shares were then traded at $260 per share, the investor's reinvested dividend would increase to 1080 shares. This process of capitalization will continue until the investor sells the shares or deactivates the automatic reinvestment program.


How to reinvest dividends

Investors can generally enroll in an automated dividend reinvestment program through their brokerage account. You should be able to find this feature in your account menu. Once selected, investors typically have the following options:

  • Automatically record all current and future stocks and funds.

  • List all current stocks and funds in a portfolio.

  • Select individual stocks and funds for automation.

Investors who choose to reinvest all current and future dividends automatically will have a truly automatic experience. This program will add new assets or funds to the plan as they enter the portfolio. Likewise, it will automatically be reinvested when a company initiates a dividend, as the initial listing covers all current and future dividend payers.

However, if an investor only enters their current plan or part of their portfolio into the plan, they will need to manually add the new stock. Therefore, they should carefully consider whether they want the convenience of full automation or retain some control over how some of their cash dividends are allocated.


Should I reinvest dividends?

There are several reasons why investors might consider reinvesting dividends. It is easy to set up, usually commission-free, often allows fractional shares, and allows investors to invest quickly. However, the best reason to consider automatic reinvestment of dividends is to benefit from the miracle of compounding.

This is evident in the returns a hypothetical investor could have earned on the S&P 500 with and without reinvestment of dividends. For example, according to data from Morningstar and Hartford Funds, an investor who placed $10,000 in an S&P 500 index fund in 1970 would have more than $350,000 at the end of 2019. This return is only a price increase because it does not pay dividends.

However, adding dividends radically changes the equation. Investors who reinvest their dividends in the same S&P 500 index fund would have more than $1.6million at the end of those 50 years.

Given this much higher income potential, investors should consider automatically reinvesting all of their dividends, unless:

  • They don't want to increase their allotment to a particular company or fund.

  • They need money to cover their expenses.

  • They plan to use the money to make other investments, such as making incentive payments to purchase growth stocks.


Dividend Reinvestment Tax

Cash dividends are often taxed, although investors automatically reinvest this money through their brokerage account or the company's DRIP. However, tax rates can vary considerably depending on the type of dividend paid (qualified or not) and the investor's taxable income. The tax rate for eligible dividends is 0%, 15%, or 20%, depending on the investor's taxable income and marital status. Meanwhile, the tax rate on nonqualified dividends is the same as the investor's normal income level, ranging from 10% to 37%.

In addition to eligible dividends received by low-income investors, another form of tax-free payment is paid in shares by companies that do not offer investors a choice between cash and shares. In a case like this, investors generally do not have to pay tax on dividends on the shares until they sell them.


More about Dividend Reinvestment Plans (DRIPs)

Most investment dealers make it easier for investors to reinvest all of their dividends by creating an auto reinvestment plan. Nonetheless, investors can also choose to participate in Dividend Reinvestment Plans offered directly by a dividend-paying company. These programs offer similar benefits to brokers, as many are commission-free and allow investors to buy fractional shares. In addition, some companies sell shares through the DRIP program at a price lower than the current market price.

However, not all Dividend Reinvestment Plans offer these benefits, so investors should read the fine print carefully. For example, some companies have minimum investments, such as holding a certain number of shares or a certain dollar amount. In addition, some also charge service fees and brokerage fees.


Conclusion

Reinvesting dividends is a great way for an investor to constantly increase their wealth. Many brokers and companies allow investors to automate this process, allowing them to buy multiple stocks (even multiple times) with each payment. This increases your income, which may increase over time.


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