When Should You Reinvest Your Dividends?

Investing in dividend-paying stocks and ETFs offers the opportunity to generate passive income. If you don’t need this income immediately, you can reinvest the dividends by using them to purchase additional shares of the same stock or ETF. This can be a powerful strategy for compounding growth. Over time, this approach leverages compounding by increasing your share count. It can potentially boost future dividend payouts and capital appreciation without requiring additional out-of-pocket investment. These are the pros and cons of dividend reinvestment to consider.

A financial advisor can help you decide how much, if any, of your dividends to invest.

What Are Dividends?

Dividends represent a percentage of a company’s profits that it pays back to shareholders.

There is potential capital appreciation from owning a stock that rises in value. You can also benefit from dividend payouts, although not all stocks pay dividends to investors.

For example, a growth stock is less likely to offer a dividend. This is because the company may reinvest most or all of its profits in growth and expansion projects.

At the other end of the spectrum are the Dividend Aristocrats and Dividend Kings. These are established companies that have consistently increased their dividend payouts year to year. Meanwhile, some companies may reduce or eliminate dividend payouts over time if profit margins shrink.

Aside from individual stocks that pay dividends, investors can choose:

Dividend exchange-traded funds. Dividend exchange-traded funds hold a basket of dividend stocks. This allows for simplified diversification and passive investing.
Real estate investment trusts (REITs). Real estate investment trusts (REITs) are another dividend option. These investments are required to pay out 90% of taxable income to investors as dividends. You might consider a REIT if you want to add real estate exposure to your portfolio.

Pros and Cons of Reinvesting Dividends

When you reinvest dividends, you use them to purchase additional shares of stock. The alternative is to receive dividend payouts in cash.

The chief advantage of reinvesting dividends is having the opportunity to purchase additional shares of stock without putting up more money out of pocket. Say you own 100 shares of stock that’s trading at $100 per share. This same stock pays a dividend of $5 per share.

That adds up to a $500 dividend payout. You can receive a deposit as cash into your brokerage account or by mail. However, with dividend reinvestment, you can also use that $500 to purchase an additional five shares of stock.

Reinvesting dividends consistently can increase your portfolio over time through the power of compound interest. When you’re ready to retire, you can transition from reinvesting dividends to using them as income. Assuming your dividend stocks increase in value, this translates to more dividend income.

Of course, dividend reinvestments are taxable as investment income, regardless of whether you receive cash or a deposit. This is one potential downside of dividend reinvestment - the potential for a larger tax bill.

However, it is possible to avoid higher taxes if you’re reinvesting dividends inside a tax-advantaged plan, such as an individual retirement account (IRA).

Should I Reinvest Dividends?

Whether it makes sense to reinvest dividends largely hinges on your investment timeline, goals and risk tolerance.

Timeline

For example, if you’re in your 30s and retirement is still decades away, you may not need the income generated by dividends. In that scenario, you could benefit more from reinvesting dividends into additional shares to grow your portfolio.

Say the market experiences a downturn. In this case, reinvesting dividends can still yield benefits over time through the power of dollar-cost averaging.

With this strategy, you can reinvest dividends to buy additional shares when stock prices are low. Continuing to reinvest dividends can also help you avoid certain investing biases that may cause other investors to sell when volatility sets in.

Increasing Payouts

Reinvesting dividends can also work in your favor if a stock’s dividend payout increases steadily. For example, Dividend Aristocrats represent companies that have raised their dividend payout for 25 years or more consecutively. Dividend Kings have raised their dividend payouts 50 years or more consecutively.

Investing in these kinds of companies means more dividends to reinvest over time. The more dividends you can reinvest, the more benefits you can draw from compounding.

Income Needs

On the other hand, you may choose not to reinvest dividends if you need them for current income. This is something you may not have to consider until you retire, but it’s possible that a job loss or an illness that keeps you from working may necessitate using dividends for income. You may also want to draw on dividends to help pay for large expenses, such as paying off your mortgage or college expenses.

Using a dividend reinvestment calculator gives you an idea of how much your portfolio might grow if you choose to reinvest. Seeing the numbers and potential growth could help you decide if reinvesting dividends is worth it.

How to Reinvest Dividends

How you choose to reinvest dividends can depend on where you hold your dividend stocks.

If you have them inside a taxable brokerage account, for example, your broker may give you the option to set up automatic reinvestments. The advantage of choosing this option is that it’s automatic, so you don’t have to remember to reinvest. Your brokerage may charge no transaction fees or commissions to reinvest dividends this way.

The other option is a dividend reinvestment plan (DRIP). These plans are offered by companies and allow investors to purchase stock directly and reinvest the associated dividends. Similar to reinvesting dividends through a brokerage account, DRIPs offer automated investing, often with little or no transaction fees.

If you’re unsure whether to reinvest dividends through your brokerage or a DRIP, a simple way to decide is by comparing fees. Investment fees can detract from your earnings so the fewer fees you pay for dividend reinvestment, the better.

A financial advisor can walk you through the options to help you choose the best strategy for reinvesting dividend payouts.

When It May Make Sense to Turn Off Dividend Reinvestment

Dividend reinvestment can help grow your investments over time, but it is not always the best option. Automatically buying more shares of the same stock or fund may increase your exposure to a single investment, particularly if it has grown to represent a large portion of your portfolio.

For example, suppose one dividend stock performs well for many years and becomes your largest holding. Continuing to reinvest every dividend into that same stock could further concentrate your portfolio, increasing the impact if the company’s share price later declines.

Some investors choose to receive dividends as cash and invest them elsewhere instead. Directing those payments toward underweighted investments can help maintain a diversified portfolio while still putting the money back to work.

You may also decide to stop reinvesting dividends if you have other financial priorities. Extra cash could be used to build an emergency fund, pay down high-interest debt or invest in other assets that better match your long-term goals.

Reviewing your dividend reinvestment elections periodically can help ensure they continue to align with your investment strategy. A decision that makes sense during your working years may be different once your income needs or portfolio allocation changes.

Bottom Line

Should I reinvest dividends? It’s an important question to consider if dividend stocks, dividend ETFs or REITs are part of your investment plan. Over the long term, dividend reinvestment could significantly grow your portfolio, though it’s important to weigh that against your current income needs. The younger an investor is the more it makes sense for that person to reinvest dividends. The older an investor is the more it makes sense to at least consider not reinvesting dividends.

Tips for Dividend Investing

Consider talking to a financial advisor about how to choose dividend stocks and whether reinvesting dividends is the right approach. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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