When to Reinvest Dividends (or Not)

If you own stocks or funds, many of your holdings likely pay dividends. When you initially set up a brokerage account, you’ll be prompted to make a reinvestment election, but after that, you might not give it much thought.

But this question deserves at least some attention. There are times when it makes sense to reinvest dividends, and other times when it doesn’t. Here, I’ll explain some of the considerations for investors.

How Dividend Reinvestment Works

Let’s get one thing out of the way first. Whether or not you reinvest dividends has no impact on the taxes you’ll pay. If you hold securities in a taxable account, you’ll pay taxes on the dividend amount regardless of whether you reinvest or not.

If you own a fund or exchange-traded fund, your brokerage account settings should include a choice to reinvest dividends or not, which can be done at the fund or account level. You can also set your preference for reinvesting stock dividends for each stock you hold in the brokerage account. Once you make this election, it will remain in place unless you change it.

If you invest through a company-sponsored retirement plan such as a 401(k), the plan administrator will typically set up the account to automatically reinvest.

Another wrinkle relates to stocks that you own directly instead of through a brokerage account. Many (though not all) publicly traded companies offer dividend reinvestment plans, which allow you to use dividend payments to purchase shares directly from the company. In many cases, DRIPs allow you to purchase fractional shares in the stock; and in some cases, you may be able to purchase shares at a small discount to the current market price. If you own shares directly and want to set up a DRIP, you’ll need to contact the company’s transfer agent, which maintains ownership records on behalf of the company.

When It Makes Sense to Reinvest Dividends

If you’re mainly investing for long-term growth, you’ll probably want to reinvest dividends. Since 1926, dividends have made up a large chunk (about 4 percentage points) of the equity market’s 10% average annualized return.

Another advantage of reinvesting dividends is simplicity; it’s one fewer administrative detail to remember and take care of. If you don’t set up your accounts to reinvest dividends, you’ll need to periodically log in to the account and decide what to do with the cash balance, such as using it to purchase another investment or transferring the proceeds to another account. Forgetting to do this is not a good idea, since dividend proceeds usually go into a low-paying “sweep account” that doesn’t pay out much in the way of yield.

When It Doesn’t Make Sense to Reinvest Dividends

Many investors like to use dividend income to cover living expenses in retirement. If you’re following that strategy, you obviously wouldn’t want to set up dividend reinvestment. However, it’s worth noting that dividend payments don’t count toward the required minimum distributions that investors age 73 and older are required to take from tax-deferred accounts, such as IRAs and 401(k)s. That means you’ll still need to sell shares to meet those requirements. The amount is calculated based on two factors: the total balance for tax-deferred accounts as of the end of the year, divided by a life expectancy factor published by the IRS.

Another case for not reinvesting dividends would be if you already have a large position in a stock or fund and don’t want to buy more of the same security. Not reinvesting dividends (and using them to invest in something else instead) can help improve a portfolio’s diversification over time.

Even if you don’t have an overly large position in a stock, you may not want to purchase more of it if it’s already trading at a significant premium. Morningstar’s analysts publish fair value estimates that can help you gauge whether the current stock price is reasonable or not.

In addition, not reinvesting dividends can make things easier from a tax perspective. If you reinvest dividends, you’ll be making small purchases every quarter, potentially leading to many separate tax lots with different cost-basis levels. That can complicate matters when you eventually sell the stock, since you’ll need to match up each sale with a specific tax lot.

What Are Your Priorities?

Ultimately, the reinvestment decision depends on what you want to prioritize in handling your finances. Setting up accounts to reinvest dividends is less time-consuming but involves more tax complexity, while not reinvesting dividends can help you fine-tune your portfolio but requires staying on top of things to make sure cash proceeds don’t languish.