But it’s not a one-size-fits-all solution. There are pros and cons that depend on your present-day finances and projected resources come retirement.
Dividend reinvestment 101
As the owner of a stock, you own a piece of the company that issued it. As such, many companies regularly give value back to shareholders in the form of dividends. There are two ways people handle them—keep the cash or reinvest it back into the company.
Dividends come in a variety of payment structures, including quarterly (the most common), semi-annually, annually and even monthly. Additional payments can come in the event of a stock split or a huge uptick in the company’s profits.
Many companies provide an automatic dividend reinvestment plan (DRIP), in which they return your dividends to the investment pool without your having to lift a finger and usually at a discounted rate. You can also buy partial shares, which typically isn’t possible when you use cash.
Why reinvest?
Better returns over time
If you’ve been saving diligently for the majority of your working years, you have a hodgepodge of accounts that may include a 401(k), an IRA, an HSA and your investment portfolio. Assuming these are enough to cover your basic living expenses come retirement, your dividends will have far better returns going back into the company than into your wallet.
The S&P 500’s total return averages out between 8 and 10 percent over time, approximately half of which comes from dividends. Assuming that the companies providing dividends continue to perform well, you will reap those rewards.
Tax benefits
Although the IRS considers dividends to be income, they are taxed at a lower rate than the money in your monthly paycheck.
Why keep the cash?
Reliable income stream
If you don’t have a level of income that allows for a more ambitious investment strategy, or simply haven’t been able to save at recommended levels, you may need those dividend dollars to provide or supplement your retirement income.
Fewer bad assets
As appealing as dividends can be, keep an eye on the overall performance of the company providing them. If over time it seems to have less and less value, it’s probably a good idea to take the cash and ditch the stock. Although the money may still be flowing, those dividends will someday stop if the company doesn’t get itself into shape.
Rebalanced portfolio
Although dividend reinvestment may cause your investment in that company to flourish over time, keep in mind that it’s just one stock. Too many dividend-bearing assets can give you an unbalanced portfolio and actually increase risk over time. A good way to clean house is to take dividends in cash and put it into other investment vehicles that can bring a healthy diversification back to your portfolio. A good time to give this real consideration is when you’ve formally entered retirement and need to start living off of your investments.
Start at the beginning
If there’s one vital takeaway from these pros and cons, it’s that there’s no one answer. Your financial goals will likely change as your life and career progress. Dividend reinvestment may be the wise choice early on, but as income goes down and medical expenses go up, your need for cash may also shift. Or maybe those consistent savings (and kale smoothies) will keep everything humming right along, allowing reinvestment to take its course.
A first step in making these decisions is to figure out what resources you’ll actually need in retirement. Our online calculator can help you start setting goals.