If you invest in a stock index, then you will not receive any dividends. But if you own shares of stock or a stock mutual fund, then you can often count on receiving dividends. And the question of what to do with those dividends can be an important one. Should you reinvest dividends or take them in cash? Dividends will have a lasting effect on the rate of return that you get from your stock portfolio and can also impact the quality of life that you have during retirement. So, what is the right answer to this question? The only concise answer that most stock brokers and financial planners can give you is: it all depends. Here we will examine the pros and cons of taking dividends in cash versus reinvesting them.
Why are dividends attractive?
The benefits of reinvesting your dividends
Why you should just take them in cash
If you decide to reinvest your dividends back into the stocks that paid them, then you will obviously increase the number of shares that you own over time. If you hold your shares in a brokerage account, then once the amount of dividend income that you receive equals the price of at least one share, you can use that money to buy another share of stock. Then you will have more shares of stock paying you dividends, which you can then reinvest again to buy even more shares, and so on.
If you do this over a long period of time, then you can substantially improve your rate of return. In addition to the growth of the stock over time, you will also have more shares paying more dividend income. Reinvesting your dividends can therefore be a very profitable trading strategy over the long run.
For example, say you own 2,000 shares of a stock trading at $100 and the company declares a dividend of $5 every quarter. You will get a dividend of $10,000 and use it to buy 100 additional shares. Your next dividend payment will be $10,500. If you buy more shares with that, then you will have 2205 shares. It becomes very apparent that reinvesting your dividends can be very effective.
The chief disadvantage that comes with dividend investing is that you cannot spend them now. If you own 2,000 shares of a company with a $5 dividend, then you will get $10,000. Say you reinvest this money into more shares of stock. Then your portfolio will become ever-more concentrated in that stock.
You may also have to pay commissions to reinvest your shares. Or you could participate in a DRIP (dividend reinvestment program) sponsored by the company. This type of plan will allow you to reinvest your shares directly without having to pay a commission to a broker. It can also allow you to reinvest partial shares. DRIP plans are the most efficient way to reinvest your dividends, but not all publicly traded companies offer this.
If you own shares of a company that does not offer a DRIP, then you will only be able to buy whole shares with your dividend money. You will also pay a commission for the purchase transaction. This will drag your overall return down over time.
The obvious advantage to taking dividends in cash is that you will have more cash to spend. If you are retired, then the money you get from your dividend payments may be used to pay for current expenses. Rent, mortgage payments, insurance premiums, or utilities could all be paid with dividends.
But your dividend payments will never grow if you never reinvest them. Many financial planners will tell you to take the dividends in cash for some months and reinvest the dividends in others. This way you have some cash to spend now as well as a hedge against inflation risk.
The obvious disadvantage to taking your dividends in cash is that they cannot grow over time. If you spend your dividends, then you will not have a hedge against inflation going forward. Of course, the company you are investing in may raise its dividends at some point in the future. But you generally cannot count on this as a reliable hedge against inflation over time.
The suitability of reinvesting dividends versus receiving them in cash will depend upon your risk tolerance, investment objectives, and time horizon. If you are retired and need current income, then taking your dividends in cash may make more sense. After all, you are going to get taxed on your dividends regardless of what you do with them.
If you receive qualified dividends, then you will only have to pay long-term capital gains tax on them. But if you are paid regular dividends, then they will be taxed at your top marginal tax rate. Both types of dividends can also affect the taxation of your Social Security income.
On the other hand, if you are still young and retirement is decades away, then you could reinvest your dividends. This way you can build up your stock holdings and grow your portfolio. But many planners would also advise you to invest them in something else, such as a mutual fund. This way, your money will be more diversified. And your financial future will not be so dependent upon the fortunes of a single company.
You may want to use your dividend income to contribute to a traditional or Roth IRA. Your money will grow tax-deferred until you retire and start taking distributions. Or you may want to use it to pay off some debts, such as your mortgage, student loans, or credit cards.
In the end, the best choice for you will depend upon your financial circumstances and what is most important to you. If you are at a point in life where you will not need your dividends to increase, then taking cash may be the best option for you. If you think that you still need a hedge against inflation in your portfolio, then you will probably be better off by reinvesting your dividends.
Dividends can be a vital part of your investment portfolio, regardless of what you do with them. One word of caution, some undervalued stocks have high dividend yields because the stock has recently sold off. Always research why a yield is high, it may be a sign of a problem!