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Should I Use a Dividend Reinvestment Plan?

March 26, 2020 · 7 minute read

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Should I Use a Dividend Reinvestment Plan?

If you’re receiving dividends from some or all of the stocks in your portfolio, then you’ve probably got two main options about what to do with those dividends: You can take the cash value of the dividends or you can reinvest them into the company that paid out those dividends.

If you choose the second option, then you’d get additional shares of stock, calculated using the current market rate, equivalent to the dollar amount of the dividends paid.

With those two broad options in mind, here are more specific examples of what you might choose to do:

•   Use that money to buy something you want or need.
•   Put the funds into a savings account for ready liquidity.
•   Take the dividend in cash and use the money to buy stocks from different companies.
•   Reinvest what you received right back into the company that paid it out to you.
•   Have your investment account set up so that the reinvestment automatically happens.

What’s right for you depends upon your financial situation and goals. To help, this post will guide you through what you might want to consider when making your decision about whether to save or reinvest dividends.

Dividend Definitions

As a couple of points of clarity, we’ll share a definition of a dividend along with what it means to reinvest yours. First, a dividend is a payment made from a company to its shareholders (people who own shares of their company’s stock).

Dividends are often drawn from a company’s earnings and paid to shareholders on an annual or quarterly basis.

Now, here’s more about what it means to reinvest your dividends. When you initially buy a share of dividend paying stock, you are buying a piece of a particular company.

When you make that purchase, you typically have the option of choosing, right then, whether you’ll want to reinvest any potential dividends earned. Or, maybe you’ll make that choice when you first open your investment account.

If you choose to automatically reinvest, if and when the company pays dividends, the funds owed to you will be used to buy more shares of that company’s stock without any action needed on your part.

Here’s an example. If you own 20 shares of a stock that has a current trading value of $100 per share, and the company announces that it will pay $10 in dividends per share of stock, then the company would owe you $200.

If you have chosen to reinvest the dividends, you now own 22 shares of that stock ($200 in dividends/$100 of current trading value = two new shares of stock added to your original 20).

If, instead, you want cash, then you’d receive $200 to spend or save, and you’d still have the initial 20 shares of the stock.

So, what should you do? Because each situation is unique, here is additional information to help you make your own decision about whether you should save or reinvest dividends.

First, What’s a DRIP?

Like just about any other industry today, the world of investing has plenty of acronyms, including DRIP. Although some people use this term more informally to refer to any automatic reinvestment of dividends, DRIP more often refers to a formal dividend reinvestment plan program that is offered by about 650 companies and 500 closed-end funds.

Tax Consequences of Dividends

There may be tax consequences when you receive dividends because if the amount is significant enough, you might need to pay income taxes on what you’ve earned.

Each year, you’ll receive a tax form called a 1099-DIV for each investment on which you received dividends, and these forms will help you to determine how much you owe in taxes on those earnings.

Dividends are considered taxable whether you take them in cash or reinvest them—even though when you reinvest, the money isn’t currently available for you to spend.

The exception to that rule is for funds invested in retirement accounts, such as an online IRA. If you have received or believe you may receive dividends this year, it can make sense to get professional tax advice to see how you can minimize your tax liability.

Pros of Dividend Reinvestment

You may have heard that Albert Einstein claimed that the most powerful force in the universe was compound interest. Although that claim is pretty dubious, it is true that one of the best reasons to reinvest your dividends is that it helps to position you for the best long-term returns possible through the power of compounding.

Generally, if a company pays out the same level of dividends each year—whether that’s 2%, 3% or something else—and you take your dividends in cash, then you’ll keep getting the same amount in dividends each year (assuming you don’t buy any additional shares).

But, if you take your dividends and reinvest them, then you’ll have more shares of stock next year, and then more the year after that—which means that the dollar amount of the dividends (at least in our example where the payout percentage is the same each year) will keep rising. Over a period of time, the amount you would receive during subsequent payouts could increase significantly.

Real-life situations aren’t often as straightforward as this example, of course. For one thing, stock prices aren’t likely to stay exactly the same for an extended period of time. The value can go up (even better for you) or go down.

Plus, there is no guarantee that dividends will be paid out each period; and, even if they are, there is no way to know for sure how much they’ll be. The performance of the company and the general economy can have a significant impact on company profitability and, therefore, typically affect dividends given to shareholders.

From a long-term historical perspective, though, stocks have provided financial growth and, when dividends are reinvested, the effect of compounding can provide significant benefits.

There are more benefits, including that some companies may not charge transaction fees when you reinvest (but don’t assume that’s true for your situation).

Plus, if you’ve got your account set up to automatically reinvest, then it’s a convenient, no-hassle way to continue to invest for the future—perfect for busy people.

Here’s another reason why it can make sense to reinvest dividends. You may not have ready cash to purchase more shares of stock, but with reinvesting you’re already doing that, even if what you’re getting is a fraction of a new share at a time.

Cons of Dividend Reinvestment

One of the most basic reasons why you might want to take your dividends in cash rather than reinvesting the funds is that you want or need the money.

Perhaps it’s time to buy a bigger house, or a wedding and reception is right around the corner—or it’s getting close to time to retire, or you just want to have more money in your savings account.

Risk factors can also play a key role in your decision making. For example, you may have concerns about the stock market in general, or about a particular company where you’re a shareholder.

As far as the first potential concern, it can be challenging to try to dovetail your dividend reinvestment strategy with market ups and downs, so in many cases it may be better to continue to reinvest your dividends than to try to outguess what the market will do.

If, though, you have specific concerns about the companies you own stock in, then this may be a sign that it’s time to look into selling those stocks and buying other shares in companies you have more confidence in.

Another thing to consider is that when your dividends are automatically reinvested, they will go right back into the company that issued the dividend, giving you no choice as to where to put those funds.

Perhaps you’d simply rather buy stock from another company. And, since dividends are usually still taxable, even though they don’t translate into readily accessible funds, you might want access to them.

Finally, you may want to not reinvest as a reallocation strategy to rebalance your investment portfolio. If you’ve successfully been reinvesting your dividends, or otherwise growing certain stocks, they may now be too large of a percentage of your portfolio.

If, after reviewing these pros and cons, you still aren’t sure what’s best to do, then it might make sense to go back to the starting point.

Why Are You Investing?

When you’re thinking about what to do with your dividends, it can help to revisit why you’re investing in the stock market in the first place.

A typical answer may be that you want to make money by choosing and investing in stocks that will increase in value, and then perhaps selling those stocks at a higher price.

As a side note, that philosophy is why you may hear the phrase “buy low, sell high.” If you buy stocks when the price is lower—and then the company is profitable—then you may have the opportunity to make a profit by selling your stock shares at a higher price. As a point of clarity, that’s not advice we’re giving you; we’re just sharing why you might hear that phrase.

Hopefully, after reviewing your original investment goals, along with discerning if and how those goals may have changed, you’ll be able to make your decision.

As part of that discernment process, you might want to review your portfolio to see what kinds of stocks you own to determine if that’s still the right mix for you today. If you think it’s time for a change, here are different types of stocks to consider.

You could, for example, have shares of stocks that are considered to be “growth stocks.” These are with companies that have sales and earnings that are going up, year over year.

In this case, the company’s management team typically won’t pay dividends to shareholders because they want to use their profits to invest in their own continued growth. Investors who are interested in dividends wouldn’t typically choose startup companies for a similar reason.

Or, you might have invested in “value stocks,” which have lower prices because of events outside of the company’s control. Investors who choose these are typically hoping that these undervalued stocks will increase in value. Sometimes, value stocks pay good dividends.

Another option is to choose stocks, typically from companies in mature industries, that aren’t growing much and provide shareholders with higher dividends.

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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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