When the stocks or funds that you own pay you dividends, it can be hard to decide whether to pocket the extra money or reinvest it. You can either take the money and use it like you would with any other income, or you can reinvest dividends and buy more shares. The choice is truly yours.
So, should you reinvest dividends?
Reinvesting your dividends can be a strong strategy that is:
- Cheap: When you buy more shares with your dividends, you won’t owe any commissions or other brokerage fees.
- Simple: Once you have set it up, dividend reinvestment is automatic.
- Flexible: With dividends, you can buy fractional shares that most brokers wouldn’t let you purchase before.
- Consistent: Every time you receive a dividend, you will buy shares. This is the dollar-cost averaging (DCA) method in action.
However, reinvesting your dividends is not always the correct answer. Keep reading to find out what dividend reinvestment really means, and why you might not reinvest your dividends.
What Are Dividends?
In layman’s terms, dividends are a reward that is paid to the shareholders of a company for their investment. They are periodic payments that are made to shareholders from the profits which a corporation makes.
Dividends are typically paid quarterly, and the amount given is decided by the board of directors of the company. This board of directors can also choose not to pay dividends and instead opt to retain their earnings to reinvest them back into the company.
What Is Dividend Reinvestment?
When you reinvest dividends, you purchase additional shares with the amount rather than take the money. By reinvesting your dividends, you’ll buy more shares in the company. This, in turn, will increase your dividend amount the next time, which will then let you buy even more shares. This will supercharge your long-term returns by using compounding.
The Power Of Compounding Through DRIPs
Compounding: The process of reinvesting your earnings to generate additional earnings over time.
DRIPs: Dividend reinvestment plans (DRIPs) are a method where shares are automatically purchased on your behalf using your dividends.
A dividend reinvestment plan allows you to automatically use your cash dividend to purchase additional or fractional shares of a company’s stock. Dividend reinvestment plans allow you to acquire shares without paying commissions, and typically, the shares are at a discounted price. This is a form of compounding and can significantly boost your investment returns over time, as, instead of taking the cash, you are reinvesting it automatically and gaining higher shares as time goes on.
When you compound your earnings with DRIPs, you can grow your wealth quietly over a steady period. Once you are ready to supplement your income, you should have a good investment revenue waiting for you.
How To Automate Dividend Reinvestment
The best way to automate your dividend reinvestment is to use a dividend reinvestment plan (DRIP) if your company offers this. It will simplify the process for you and, once set up, you won’t have to lift a finger. The cash dividends you receive will go straight into reinvesting. Alternatively, you could do this process yourself, but there is a chance you would change your mind and opt for the cash instead.
Most UK brokers automatically reinvest dividends if you enable this option in your account settings.
Why Would You Not Reinvest Dividends?
Although reinvesting your dividends can have many benefits, there are also times when you should consider taking the cash amount.
Retirement
If you are nearing retirement, it might be a good idea to consider your earnings and decide whether you could benefit from keeping the dividend income. Once you retire, you will no longer have your wages as a regular source of income, so it could be a good idea to look into what you will earn from your retirement accounts and other sources of income before deciding to reinvest dividends.
However, if you find that you won’t need the extra earnings from your dividends, then you can keep reinvesting them and growing your investment.
Poorly Performing Assets
If the stocks you are investing in seem to have stalled or it is no longer providing value, it could be time to stop reinvesting your dividends into them and maybe even sell the shares so you and invest in others. However, all stocks and funds experience price fluctuations, so try not to be too hasty with your decision.
A Diverse Investment Portfolio
If you want a diverse investment portfolio, you should consider taking the dividends in cash so that you can invest them elsewhere rather than reinvesting them into the assets you already own.
An Unbalanced Investment Portfolio
If you find yourself overweight in a few investments, it could be time to study your assets. Having an investment portfolio that is overweight can yield great results, as higher-yielding, faster-growing assets can build up quicker than other assets, and when these perform well, you will see the positive results. However, if the securities underperform, you could stand to lose a lot more than if your portfolio were more equally balanced.
If you Reinvest Dividends Are They Taxable?
If you reinvest dividends, you will still get taxed on them. Think of it like receiving the cash amount; you will still owe the tax on any dividend amount that exceeds the tax-free dividend allowance. For the year 2024/2025, the allowance is £500.
The only way you will not owe tax is if you are under this allowance or your dividends are held in a tax-exempt account such as a pension or a stocks and shares ISA.
Is It Better To Receive Dividends In Cash Or Shares?
Ultimately, the choice is yours. If you know you want to build on your shares to make a higher investment return later down the line, then reinvesting your dividends and taking the amount as shares would be better for you. However, if you would prefer the cash amount, or maybe even invest the money into other, newer assets that you don’t already own, then taking the cash amount would be preferable.
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