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What Is The Dividend Reinvestment Tax?

What Is The Dividend Reinvestment Tax?

There is no such thing as free money, but dividend reinvestments come pretty close.

You will likely see assets classified as dividends in your accounts during your investment journey. Dividends are payments returned to investors, usually when a company makes a profit. Stocks and funds can pay dividends, and the amount and frequency of the dividends paid can vary by company or fund.

Dividends are regarded as income, so it's up to you to do with that income as you wish. Many people choose to use the money gotten from the dividends to reinvest in the same companies or funds, while others choose to take the money. While receiving the cash may make sense for those in the later stages of their investing journey, experts say reinvesting dividends and capitalizing on the magic of compound growth is the best decision for most investors.

Here's all you need to know about dividend reinvestment and how you can use it to grow your money.

What is dividend reinvestment, and how does it work?

When businesses make more profit than they spend, they can reinvest the extra money in their own business and pass it on to shareholders as a dividend to share the profits. You can look at dividends as a way for companies to reward long-term shareholders who hold their stock.

Not all companies offer dividends. Some companies choose to reinvest in research and development to grow their business and increase their stock price, while others share their profits as dividends with investors. Businesses with a proven track record of increasing dividend payments to investors each year are known as Dividend Aristocrats and Dividend Kings.

When a dividend-paying fund or stock declares a dividend, it is paid out to shareholders, usually in cash but sometimes in additional shares. Dividend reinvestment plans, also known as DRIPs, allow shareholders of certain stocks to use their dividends to purchase additional shares, in whole or in part, of stocks, ETFs, or mutual funds at no additional cost.

If you decide to reinvest your dividends, the money will be used to buy additional shares of the underlying investment, increasing your holdings in the company or fund.

Reinvesting dividends makes the money work for you. You're generating income on top of your income, and that's the power of compounding.

You can also decide to take the cash with you to spend whatever you want, such as living expenses coverage. Or, if you want to limit your investment to a certain company or fund, you can take the cash dividend and use the money to buy other investments to further diversify your portfolio.

Should you reinvest or take the money?

Whether you need to reinvest your dividends or get your money's worth depends on two main factors: whether you want to add more stocks or funds of the same stock to your portfolio and where you are in your investment plan. 

Although it may be tempting to take the money, reinvesting may be more beneficial to you in the long run, especially if you receive regular dividend payments from profitable investments. If you have a long-term investment or don't need the extra income, experts recommend reinvesting your dividends by buying more shares—this way, the money you earn is used to earn even more money for you in the future.

But if you're retired or need extra income, dividends can be a valuable source of extra income. Many retirees use their dividends for day-to-day expenses.

If you're saving for retirement while working and don't need dividend income, you'll probably want to reinvest it. When you retire, you will enter the distribution phase and begin to withdraw money from your portfolio to support your lifestyle. At this point, you may be inclined to receive dividend income rather than reinvest it if it is part of your income needs.

Ultimately, the best answer will depend on where you are in your investing journey.

How to reinvest dividends

Most stock exchange accounts have settings that allow you to sign up for automatic DRIP plans. Once you've found your transfer options, you should see the following options:

  • Reinvest all current and future stocks and funds

  • Reinvest all current stocks and funds

  • Reinvest selected stocks and funds

When you sign up for a DRIP plan, you get an automatic, set it, and forget it, experience. When a company or fund posts a dividend, its brokerage firm buys several assets in your name and adds them to your account, these purchases are usually free, and the money will be used to purchase more of the same support fund. If the amount of the dividend is not enough to buy a whole share of the stock or fund, most brokers will allow you to buy fractional shares. All of this usually happens within days of receiving a dividend.

Keep in mind that most employer-sponsored retirement accounts and some IRAs will automatically reinvest dividends by default. If you are not sure of the status of your request, please check your account settings or contact a finance professional who can help you with your account.

Professional Tip

When you save for retirement, you'll probably want to reinvest your dividends to keep your money working for you.

If you don't want an automatic dividend reinvestment plan, you can choose to take cash and use it to buy more suitable stocks or funds. Some investors will save money and buy more bonds when the market drops, although trying to time the market is not necessary for long-term index fund investors. Others may take advantage of income stocks to buy growth stocks. Or you can take the cash and buy other stocks or funds to further diversify your overall portfolio.

Tax implications of reinvesting dividends

Every time there is revenue, the government wants its share of taxes. Dividends are no exception.

The tax implications are the same whether you decide to reinvest the dividends or take the cash. Although dividend reinvestment does not offer any particular tax advantages, you will still benefit from being taxed at a lower rate on long-term capital gains. Dividends received in the form of shares are generally taxed when the shares are sold.

Qualifying dividends, i.e., held for some time in domestic corporations, are taxed at long-term capital gains of 0%, 15%, or 20%, depending on the investment class. 

Non-qualified or regular dividends are those that do not meet the IRS criteria for special tax treatment and include dividends from real estate investment trusts (REITs), limited partnerships (MLPs), foreign corporations, and special dividends from individual companies dividend payments. These dividends are taxed as ordinary income.

With most retirement accounts and traditional IRAs, you will pay taxes when you withdraw money (after age 59½) at the current tax rate. The exception is the Roth IRA, where you invest in after-tax dollars, but your investments, including dividends, grow tax-free. It's one of the many reasons to choose a Roth IRA as a young investor.



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