Should You Reinvest Dividends or Take the Cash?
In the world of investing, a profitable investment isn't just defined as one that increases in value.
Notably, some investments make payments to shareholders called dividends.
Investors often have to choose between two options for handling these dividends:
- Should you reinvest the money you receive from them?
- Or, should you take the cash and run?
Here’s what you should know about dividend payments so that you can determine whether you should choose to reinvest your dividend check or not.
What Are Dividends?
Dividends are payments from companies to their shareholders.
Generally, companies make dividend payments to distribute some of their profits back to their shareholders.
Companies usually make dividend payments on a regular schedule.
Some businesses may pay dividends monthly, quarterly, twice a year, or annually.
Regular dividend payments aren’t required, though.
Sometimes, dividend payments are made on an irregular basis. This may happen only when a company builds up excess profits. These irregular dividend payments can be the only dividend payments a company makes.
They can also be unscheduled dividends within a regular dividend schedule.
Unscheduled dividends are often called special or extra dividends.
While dividends are usually paid in cash, they may be paid in company stock in some instances.
Some companies that pay dividends over the long term get categorized in particular ways.
This is generally due to their dividend payment history.
For example, some dividend stocks are called dividend aristocrats.
These companies must:
- Be in the S&P 500 index
- Pay and raise dividends annually for at least the past 25 years
How Dividends Work
Dividends work in a reasonably straightforward way.
There are a series of dates related to each dividend payment. These dates govern which shareholders get paid and when they get paid.
The first thing that happens in a dividend payment is a company announcing the dividend.
When the dividend is announced, the company shares three significant dates:
- Ex-dividend date
- Record date
- Dividend payment date
Stockholders that hold shares before this date will receive the dividend payment.
You won't qualify for this particular dividend payment if you buy the stock on the ex-dividend date or after.
This is usually the business day after the ex-dividend date.
The company uses this date to take a snapshot of who the shareholders of the company are.
These are the people that receive the dividend payment.
Dividend payment date
This is the date you receive your dividend payment.
When a company’s stock passes the ex-dividend date, the stock price usually drops.
This is because new shareholders don’t get that dividend payment.
They take this into account when purchasing shares.
The good news is, the drop is usually about equal to the dividend payment.
This means current shareholders can reinvest the dividend payment.
If they do, they come out even in many cases.
What Investments Typically Pay Dividends?
You may receive dividend payments from several types of investments.
Stocks are the most obvious investment that pays dividends.
After all, a dividend payment is a payment from a company to its shareholders.
Other investments may also pay dividends.
Mutual funds and ETFs both may hold shares of stock from companies that pay dividends.
These investments may make dividend payments to you to pass along the money from the companies held within the funds.
What is Dividend Reinvestment?
If you hold shares of a company in a brokerage account, you typically have two options about what to do with your dividend payments:
- Receive the dividend as cash
- Reinvest the dividend automatically into more shares of the company
Receive dividend as cash
First, you can choose to receive the dividend check as cash in your brokerage account.
If you choose the cash option, you can do anything you want with the money.
You could buy shares of a different stock or use the money to buy a latte at your favorite coffee shop.
The other option is reinvesting the dividend payment into the same company that pays the dividend.
You can choose to reinvest the dividends yourself manually, but that takes a lot of effort.
Thankfully, brokerage firms normally provide a dividend reinvestment feature.
If you choose to use this feature, the company will automatically reinvest the dividend payment into more shares of the company or fund that made the dividend payment.
Dividend reinvestment plans
If you own stock outside of a brokerage account, some companies offer dividend reinvestment plans or DRIPs.
These companies allow you to buy stock and automatically reinvest dividends.
This is done directly through the company rather than a brokerage account.
DRIPs usually let you buy fractional shares of stocks with your dividend reinvestments, too.
Pros and Cons of Dividend Reinvestment
When dividend reinvestment makes sense
First, dividend reinvestment only makes sense when you can afford to pay the taxes on the dividend payments.
If no taxes are due or you can afford the taxes, reinvesting dividends may make sense.
The main reason to automatically reinvest dividends is being in the accumulation phase of your investment plan.
Reinvesting dividends gives you the ability to buy more shares of a company that you feel strongly enough to invest in.
This reinvestment can help you purchase more shares of the company. The more shares you own, the more the power of compounding returns could help your investment’s value grow.
If the company makes regular dividend payments, you can view the automatic reinvestment as dollar cost averaging into more shares of the stock.
The Alternative - Keeping the Cash
As mentioned above, the alternative to automatically reinvesting dividends is keeping the cash.
You can use the money any way you wish.
This gives you the ultimate flexibility.
Pros and Cons of Cashing Out Dividends
When keeping the cash makes sense
Reinvesting dividends doesn’t always make sense.
If you can’t afford to pay the taxes, you can take part of the cash to pay the dividend tax.
Then, you can manually choose to reinvest the rest of the payment if you wish.
If you’re in retirement, you may view dividends as income used to fund your lifestyle.
In this case, reinvesting dividends may not make sense.
You may be at a point in your life where you’re comfortable that your portfolio will help you reach your retirement goals.
In this case, you may decide to use dividend payments for other needs.
How Dividends Are Taxed
Another important consideration is the taxation of dividends.
How you pay taxes on dividend income depends on what account type you hold the dividend-paying investment in.
If dividend-paying stocks are held in retirement accounts, you generally don’t pay taxes immediately.
That’s because retirement accounts typically allow earnings, including dividends, to grow tax-free.
You may have to pay taxes on withdrawals in retirement depending on the account type, though.
Taxable brokerage accounts
You normally have to pay taxes on dividends received in a taxable brokerage account.
Dividends can be qualified or unqualified.
Qualified dividends receive a preferential and lower tax rate.
To be a qualified dividend, the dividend must be paid by certain company types.
U.S. corporations and certain foreign entities may qualify.
In addition, you must hold the stock for 60 days during a specific 121-day period.
The period begins 60 days before the ex-dividend date and ends 60 days after the ex-dividend date.
If you do not meet these requirements and the IRS’s definition of a dividend, the dividend will be taxed as an unqualified dividend.
These dividends require you to pay income taxes at your ordinary income tax rates.
The good news:
You should receive a 1099-DIV tax form detailing your total dividend payments.
It should also specify the dollar amount of qualified and unqualified dividends you received.
Consult an Expert
If you’re unsure what to do with your dividend payments, you may want to consult a fiduciary fee-only financial advisor.
These advisors do not accept commissions so they should not have any conflicts of interest.
They can take a look at your entire financial situation. Then, they can advise you on whether you should reinvest dividends paid to you. They may also help you create an investment plan that goes deeper than whether you should automatically reinvest dividends.
You do have to pay them for their time. However, the advice they give must be in your best interests due to their fiduciary duty.
This can give you peace of mind you aren’t being sold something just so the advisor can earn a commission check.