The decision to reinvest dividends is not as straight-forward as most think and there are a few scenarios where you should NOT reinvest dividends.
Should you reinvest dividends or not? Seems like it should be a quick yes or no answer. A lot of investing ‘experts’ and blogs will make it seem like it is and will tell you without hesitation that you should reinvest.
But wait…there’s more!
Just like most investing decisions, always going with what may be right for the majority of investors is a good way to lose your money. Understand that the investing industry is a mass market business. That means blogs and online advisors have to give advice to as many people as possible all at once…preaching investment advice to the masses. It also means it is probably bad advice for your specific needs and goals.
Instead of some generic advice, let’s look at the reasons you should reinvest dividends as well as other questions you should be asking. Then I’ll show you specific instances where you would NOT want to reinvest your dividend income.
Should I Reinvest Dividends?
The answer of whether you should reinvest dividends is pretty straight forward for most investors but there are some situations when you wouldn’t want to reinvest that I’ll share later. Let’s look through the reasons to reinvest first, which will apply to most investors, and keep reading for when to stop reinvesting.
The power of reinvesting dividends is that it gives you the opportunity to make money on those dividends. Imagine a dividend stock, in fact we’ll use shares of Altria (MO) as an example. If you bought the shares at $25 each in 1992 and sold today at $55 per share, you would have made just 2.6% a year on the share price. Don’t worry though, you would have collected over $137 in dividends over the 30 years so you actually made more like 7% a year.
That’s not bad but it’s nothing compared to how much you would have made if you reinvested dividends into buying more shares over that time. If you had done that, you would have made 13.3% a year or about 44-times your original investment!
If you’re still in doubt, take a look at the chart below. All three lines are of a $1000 portfolio invested over 30 years. The blue line at the bottom represents a portfolio of stocks with no reinvestment, reaching $2000 over the period or an abysmal 2.3% annual return. The red line is a portfolio of no-growth dividend stocks, reaching about $4,500 over the 30 years…that 5% annualized return is better and proves the power of dividend stocks but it’s nothing compared to investing in dividend stocks that grow the dividend AND reinvesting the payments!
That portfolio of growth dividends reinvested would reach $9,000 over the same period, a return of 7.5% a year.
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How to Reinvest Dividends
So if the answer of whether to reinvest dividends is a no-brainer for most investors, then how should you reinvest? It might seem like an obvious question but there are a few details you need to consider.
Should you automatically reinvest dividends or do it yourself? Should you reinvest dividends back into the same stock, across your entire portfolio or into other stocks? When should you reinvest dividends?
Some investing apps like M1 Finance allow you to automatically reinvest dividends back into your portfolio or a single stock. It’s a great feature because it takes the guesswork and stress out of investing. You simply turn it on and know that your dividends will immediately start making money for you.
But you might not always want to reinvest dividends back into the same stock or across your entire portfolio. That’s when the do-it-yourself approach comes in handy. The truth is, letting your dividends sit as cash in your account for a month before you get to reinvesting them isn’t going to lose you much money. Most dividend stocks only declare dividends every three months so you have plenty of time to decide where to invest your money.
What is a Dividend Reinvestment Plan (DRIP)?
Some stocks have what’s called a Dividend Reinvestment Plan or DRIP. If the plan is available, most investing apps will allow you to sign up. Each time that stock pays a dividend, it will be automatically reinvested in the same stock. It’s a great option to have if your investing website doesn’t offer the feature for auto-invest of dividends.
The problem with DRIP plans, something we’ll talk about again when we get to reasons not to reinvest, is that it takes the decision out of your hands. You are signed up to automatically reinvest your dividend into buying more shares of the same company and it may take time to withdraw from the program if you choose.
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Do I Pay Taxes on Reinvested Dividends?
This is a common question I get about reinvesting dividends. Investors imagine that if they aren’t actually taking the money out of their account then it’s not like the income they collect and they shouldn’t be taxed on it.
Sorry, Uncle Sam wants his taxes.
Anytime a stock you own pays a dividend and it is paid to your account, whether you reinvest it or it sits in your account as cash or you withdraw…you will have to pay taxes on it next year. Your investing app will send you a form 1099DIV each year that will add up all the dividends from stocks paid in the prior year. There’s no difference in what you did with those dividends. In the eyes of the government, you still collected money and owe a cut to Uncle Sam.
Of course, there are ways to lower the taxes you pay on dividends. If you hold your dividend stocks for at least 60 days then you pay the long-term capital gains rate. That’s usually lower than your income tax rate which is the rate you pay on any dividends collected from stocks you held for less than 60 days.
When You Should NOT Reinvest Dividends
I did say there were some investors that would NOT want to reinvest dividends. The obvious answer would be for those that are living off dividends like retirees. If you are spending down your investments to pay the bills then you’re not going to be reinvesting.
But that’s not the only scenario where you might not want to reinvest dividends and the other two aren’t so obvious.
Another reason would be if you don’t need the income LATER. This might sound confusing so let me explain. Let’s say you’re 45 and already have a million dollars socked away in a retirement portfolio. You estimate you only need about $2,000,000 to retire on at 65 which would be a very modest 3.5% annual return…something your stocks should easily reach over the next two decades. That means you can probably enjoy spending your dividends when they get paid now because you won’t need the reinvested growth to reach your goals.
So if you’re already well on your way to reaching the portfolio you need, think about whether you even need to reinvest the dividends or not. Go ahead, live a little!
Another reason you might not want to reinvest dividends is if you just don’t think prices are right in stocks. I’m constantly amazed how often people point out that companies buyback their shares at the wrong time, often paying too much when stock prices are high, but those same investors think nothing of blindly reinvesting dividends at any prices as well.
If you think stock prices are in a bubble or even if an individual stock is just too expensive, there is nothing wrong with sitting on that cash dividend instead of reinvesting it…or better yet, invest it in a Series I Bond that pays a guaranteed 9% interest rate!
The decision to reinvest dividends isn’t as straight forward as many investors assume. While it’s smart for most investors to reinvest, growing their portfolio even faster, it’s not always the case. There are taxes to consider as well as how you want to reinvest. Like most investing decisions, don’t just go with the ‘conventional wisdom’ or what you hear ‘most investors’ should do. Always make the decision that makes the most sense for you.
Read the Entire Dividend Investing Series