Should you reinvest your dividends?

When you earn dividends as an investor, you have options: Keep the money you earn or reinvest it by automatically using it to buy more shares of the stock. What you decide to do depends on your future goals and your current financial needs.

Reinvesting dividends makes sense if your goal is to grow your portfolio more quickly and you don’t need the dividend money right away. However, if you need predictable cash flow, are saving for short-term goals or like to be more hands-on when deciding what to invest in, reinvesting dividends may not be right for you.

Here are some things to consider when deciding whether to reinvest your dividends.

What ‘reinvesting dividends’ means

Some companies or investment funds pay periodic dividends to shareholders to share the profits. Dividends are often paid quarterly, but they can also be paid monthly, semiannually, annually or on an irregular schedule.

If your investments pay dividends, you may want to reinvest that money automatically. In many cases, you can do so using a dividend reinvestment plan (DRIP).

What is a DRIP and how does it work?

Typically, you can sign up for or opt into a DRIP through your brokerage firm when you buy a stock or fund that pays dividends. You’ll likely be asked by your broker before the first transaction is final whether you want your dividends reinvested or not. Once you opt to reinvest dividends, you can usually choose how the money will be treated for each holding. So, in theory, you could keep some of your dividends in cash and reinvest others.

Many publicly traded companies and mutual funds also offer their own DRIP, allowing shareholders to reinvest their dividends directly, often without charging commission.

When you reinvest your dividends through a DRIP, the amount you’re reinvesting may not be enough to buy full shares. In these cases, you’ll buy a fractional share. Typically, the purchase will happen shortly after the dividend is paid.

Signing up for a DRIP can be convenient and make reinvesting dividends easy. But it’s important to realize that a dividend payment is still taxable if it’s in a taxable account – meaning it’s not in an individual retirement account (IRA), 401(k) or other account that offers tax-deferred growth.

When reinvesting dividends could make sense

Reinvesting dividends could help your investment account balance grow faster, though returns are never guaranteed.

When you use the dividend money you receive to buy more shares, you increase the amount you have invested. This means you could potentially earn returns on a larger investment, and you could potentially grow your balance without having to put in more money from your own bank account.

There are many situations where reinvesting dividends may make sense. For example, this option could be right for you in the following circumstances:

You have a long investment time horizon

Usually, you’re paid dividends when you own shares of an individual company or a fund that’s invested in individual companies and that company or fund makes a profit. That means you’re invested in the stock market and are exposed to market risk.

Reinvesting dividends puts more money into the fund or stock you own, which then makes up a larger share of your portfolio. It’s important to note that you increase your exposure to risk when more of your total invested money is in one company or fund.

This may be fine if you have a long time horizon and don’t need the money in the account for several years. As a younger investor, you might be able to afford to take on more risk, since you have more time to wait out market downturns and potentially recover from losses. Plus, reinvesting your dividends could help you harness the power of compound growth over the long term.

You don’t need the income today

If you’re counting on your dividends to provide income, reinvesting wouldn’t make sense – you’d be buying shares only to turn around and sell them to generate income. So if you don’t need the cash flow, reinvesting your dividends could make sense.

You want a set-it-and-forget-it approach to investing

When you reinvest dividends, you’re making steady contributions to your investments each time the dividend is paid. You don’t have to decide what to do with the money or when to invest – you're steadily buying shares on a regular schedule whenever dividends are paid.

You're investing in a tax-advantaged account

If the money is in a 401(k), IRA or other account where you don’t pay taxes on dividends, you can reinvest without worrying about taxes right now. That’s not how it works in a regular self-directed brokerage account – you'll need to understand how taxes work on investments that pay dividends.

When taking dividends in cash could be better than reinvesting them

There are also circumstances where taking dividends in cash could make more sense. Here are some examples:

You need money

Dividends can be a steady and reliable source of cash, which can be helpful if you’re in or near retirement. You’ll need to actually take the money, though – not reinvest it. Reinvesting introduces uncertainty and may not make sense if you need the dividend money to help cover your bills. Dividends are also not guaranteed.

You’re rebalancing your portfolio

When you reinvest your dividends, you’re putting that money back into an investment you already hold. As a result, this investment will make up an increasingly larger share of your portfolio. You could become overinvested in that specific company or fund, which can increase your risk.

If you take your dividends in cash, you can invest the money in other things instead of further concentrating your portfolio in one stock or fund.

You’re saving for short-term goals

If you’re building an emergency fund or have a short savings timeline, reinvesting dividends may not make sense because you don’t have time to wait out downturns or recover from losses.

Taxes and account types

It’s critical to understand that reinvesting dividends doesn’t mean you won’t be taxed on the money the company or fund pays you.

Rather, whether you owe tax or not depends on the kind of account your investments are in. You’ll want to think about after-tax outcomes when you first decide whether to reinvest your dividends.

Taxable accounts

If your investment is held in a taxable account, like a self-directed brokerage account, then you’ll owe taxes on your dividend payment in the year it is received. This is true whether you reinvest the dividend or not.

In theory, if you didn’t reinvest the dividends, you could use that money to help pay any taxes you owe come tax time. If you reinvest them, you’ll have to pay those taxes from a different source. You may also need to keep records of the cost basis – the amount you paid for the shares every time you bought more of them – so you can pay the correct amount of tax.

When considering the tax implications of reinvesting dividends, make sure you know whether your dividends are qualified or nonqualified, as this also affects how you’ll be taxed:

Understanding what kind of dividends you’re reinvesting can help you estimate your tax bill. In turn, estimating your tax liability can help you decide if you can afford to reinvest all your dividends and still pay the IRS what you owe on the dividend income.

Tax-advantaged accounts

If you receive dividend payments from investments held in tax-advantaged accounts, you avoid the current-year tax friction you’d face if the account were taxable.

Essentially, this means you can collect your dividends without your returns being reduced by taxes. In addition, you won’t have to worry about an IRS bill in the year the dividend is paid.

Reinvesting dividends in tax-advantaged accounts can make a lot of sense because you’re letting the money continue to grow without giving the IRS a cut of the profits. Just remember that you will eventually have to pay some sort of tax on distributions in the future.

Costs, timing and behavioral benefits

When you’re deciding if you should reinvest your dividends, the potential costs, timing and behavioral benefits can also affect your decision. Here are a few key things to think about:

Fees

Many brokerages offer commission-free DRIPs, which can help you save on investing fees. However, you’ll need to confirm whether there are any fund or transaction fees charged for participation in the DRIP.

Dollar-cost averaging effect

When you reinvest dividends, you’re investing a steady amount on a regular schedule. This technique, called dollar-cost averaging, can work well because you end up buying more shares when the price is low and fewer when the price is high.

Behavioral upside

Automatically reinvesting dividends means you aren’t trying to time the market, and you don’t have to make decisions on what to do with the money. This can help reduce the chance of making emotional decisions when it comes to your investments.

A simple decision framework

So, that brings us back to the question, should you reinvest your dividends? To make that decision, ask yourself a few questions:

Hybrid options to consider

Deciding whether to reinvest your dividends or not doesn’t have to be an all-or-nothing proposition. You can reinvest some dividends but not others. For example, you could do the following:

These options may give you the best of both worlds.

The bottom line

Reinvesting dividends makes a lot of sense in some situations but not in others. By carefully considering the tax consequences and your goals for the money, you can decide what’s right for you. Evaluate the pros and cons and ask yourself the key questions mentioned above before you make your choice. And if you’re not sure, seek guidance from a trusted financial professional who can help you decide what dividend reinvestment strategy is right for you.

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