Knowing How Dividend Reinvestment Works Is Key For Every Dividend Investor
When I was preparing to write this article about what is dividend reinvestment and how it works. I realized it was much more than just serving up some boring facts.
What I realized is this: reinvesting dividends (or not) is a lifelong journey.
At least it has been for me and my personal finances. And maybe it will be for yours too.
Thus, no matter what stage of life you are in. And where you are at in your journey as a dividend investor.
You must understand what it means to reinvest dividends and how to go about it.
That’s today’s goal. So, let’s get started…
What Is Dividend Reinvestment?
Most good companies seek to reward their stockholders. One way of doing this is by paying cash dividends.
As a shareholder, just like any other cash you earn. For example, your paycheck from work.
The cash from dividends is yours to do with as you please. And it can never be taken away.
Thus, you can spend it, save it, give it away, lend it out, invest it elsewhere, or reinvest it back into dividend stocks.
Many investors choose to do the latter with their dividends. Specifically, reinvesting them.
Typically, dividend reinvestment is done automatically. Right back into the stock that paid the dividend.
However, in more general terms, reinvesting dividends means investing cash into one or more other stocks. Being held as part of a dividend investor’s broader, multi-purpose dividend stock portfolio.
Next, I want to unpack this definition. By doing so, you will better understand how dividend reinvestment works…
Disclosure: At no cost to you, I may get commissions for purchases made through links in this post.
How Does Dividend Reinvestment Work?
First of all, dividend reinvesting can be accomplished in a variety of different ways. Furthermore, by knowing the different methods. You will better understand the meaning of dividend reinvestment.
Company Sponsored Dividend Reinvestment Plans (DRIPs)
The first method is done through company-sponsored programs. Also known as “DRIPs”
So, how does a dividend reinvestment plan work?
It is a formal program set up either by the company issuing the stock. Or, a third-party administrator on the company’s behalf.
DRIPs typically give shareholders the option to purchase additional shares. And more importantly, for today’s discussion, reinvest their cash dividends paid. Doing so right back into additional shares of stock within the company’s DRIP program.
In either case, the shares are normally purchased directly from the company. Inclusive of any fractional shares that are required.
There are hundreds of publically traded companies that offer DRIPs. PepsiCo (NYSE: PEP) is a good example.
You can find others by doing a little research. As I have done for Pepsi. Just look on any company’s investor relations website.
DRIPs are near and dear to my heart. Because that’s exactly how I got my start in dividend investing
As a 10-year-old kid in the 1970s. I mowed lawns in my neighborhood and delivered newspapers.
With the profits, which were meager at best. My Dad helped me set up a DRIP program in a local company.
Thank goodness for my Dad getting me started investing. Because at that age, I could have come up with plenty of reasons not to invest in dividend stocks.
Heck yeah. I wanted to spend that money!
But, as I got older, I got wiser. And I invested in one or two more such plans. On the other hand, I quickly tired of them as my dividend stock portfolio grew.
Because they created too much administration. Dealing with each company directly. And too many tax forms.
On the other hand, DRIPs are great for teaching young children about investing.
They are also fine for anyone who holds stock in just a few different companies. Or, an individual who doesn’t mind dealing with the additional administration.
But for the rest you. Here is another and more efficient way to go about reinvesting dividends.
Broker Managed Dividend Reinvestment
Most investors, like you and me. We buy and hold the best long-term dividend stocks in a brokerage account. And many brokers will automatically reinvest dividends for you.
As a result, on the day a stock you own pays its dividend. Your broker will take that cash and immediately buy more shares for you in the company’s stock.
Based on my experience, you can elect to reinvest dividends in all of your stocks. Or, just some individual ones of your choosing.
The specific services offered will depend on your broker. So, check their website. Or, pick up your smartphone and give them a call.
After I tired of individual company DRIPs. I reinvested the dividends I received through my stockbroker.
All of them for that matter. Be they paid by stocks or mutual funds.
I did this through the dog days of my working career. My investment philosophy at the time was if I owned a stock, I should desire to reinvest the dividends. Otherwise, why own the stock?
Here’s what I liked about this approach to dividend reinvestment…
First, I was busy working 50-plus hours per week. So, having my dividends reinvested automatically was a big relief. Limiting the number of investment decisions I had to make.
Furthermore, I liked the benefit of dollar-cost averaging (DCA).
DCA meant buying more shares when stock prices declined. And fewer when prices were high. Thus, lowering my cost on a per-share basis.
Using DCA is a little safer approach to dividend investing. Since you don’t after to worry about market timing.
Finally, when tax time rolled around, I only had one consolidated tax document from my broker to deal with.
Next, I have one more method to discuss. As we further our knowledge about how dividend reinvestment works…
Lump-Sum Dividend Reinvestment
I call this last approach to reinvesting dividends the lump sum method.
It is where the investor allows their dividends to accumulate in cash. And then periodically, takes the cash and reinvests it into one or more of the dividend stocks in their portfolio.
Also, it’s perfectly acceptable to reinvest the dividends received into an entirely new and different dividend stock. Thus, further diversifying the portfolio.
You can apply this method either through dividends received from a stock broker. Or, by electing to receive dividends in cash from a company-sponsored DRIP.
Just be sure you are picking good dividend stocks. To help, I have two favorite advisory services that I use and recommend.
The first is the Simply Investing Report and Analysis Platform. Simply Investing provides an interactive database covering hundreds of dividend stocks.
Complete with all the necessary dividend metrics. And recommendations on which stocks are the best buys at the time.
The second is the Motley Fool Stock Advisor. It sports an outstanding long-term stock selection track record.
By signing up with Motley Fool. You will get their top stock picks delivered to your inbox every month.
Both of these services have been part of my investing journey for a long time. And speaking of that journey, here’s how lump-sum dividend reinvesting fits into it…
I guess it was somewhere around my 50th birthday. Shortly after I retired early from my career in the corporate world. And started working part-time teaching university business courses.
At the time, I wanted more control over where our investment dollars were going.
Because we owned some dividend stocks that had become large portions of the portfolio. And some smaller positions that I wanted to add to more aggressively.
So, I let our dividends accumulate in the cash account at my broker. And every so often, I selected one or more dividend stocks where I would reinvest the proceeds. Lump-sum!
But, the next choice is always yours (and mine)…
Taking The Cash Instead
Finally, now that we use our dividend stocks to fund living expenses. As part of our financial plan for retirement and dividends.
All of our dividends go to cash. Then we spend them as we see fit.
That’s one of the great things about how dividend reinvestment works. Specifically, you can stop reinvesting dividends anytime, for any reason.
It is your passive income stream from dividends, so the decision is yours.
Next, I have a very important point that you must understand. Specifically, what does it mean to reinvest dividends as it relates to your income taxes…
Dividend Reinvestment And Income Taxes
Among the many pros and cons of reinvesting dividends. Taxes may be the most misunderstood.
Because even if you choose to reinvest all of your dividends. Unfortunately, income taxes are usually due.
It will depend on your income level. And your specific tax situation. Thus, I can’t speak to your specific situation.
So, it’s a good idea to consult with a tax professional.
Of course, you can always buy and hold your dividend stocks in a Roth IRA (individual retirement account). By doing so, no tax will be owed on the dividends your receive.
Whether you choose to reinvest them. Or, not.
There are many great investment companies to set up your IRA. In case saving for the future has been on your mind.
Finally, just be aware that when you are reinvesting dividends. And they are subject to income tax. You will need to have cash set aside to settle your tax bill.
Should You Reinvest Dividends?
For long-term dividend investors who do not need their dividends in retirement. Or, need the cash for other purposes. And can afford to pay any taxes due from other income sources…
Then reinvesting dividends is an excellent way to compound wealth more quickly. Also for taking advantage of fluctuating stock prices. To buy more shares when stock prices are down. But fewer shares when prices are up.
As you can see from my personal story. I’m a firm believer in dividend reinvestment plans.
Yes, there are good reasons for and against reinvesting dividends. And you should carefully consider them before deciding exactly what to do.
Okay. I think that covers it.
So, allow me to close with a few parting thoughts…
Recap: What Is Dividend Reinvestment And How It Works
Hopefully, I have helped you understand what it means to reinvest dividends. And how different dividend reinvestment plans work.
Your options include:
- Company-sponsored DRIPs
- Asking your stock broker to automatically reinvest your dividends
- Self-directed lump-sum dividend reinvestment
Also, know that you can stop reinvesting dividends at any time. For any reason, you see fit.
That’s all for now. And thanks for reading.
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Author Bio: Tom Scott founded the consulting and coaching firm Dividends Diversify, LLC. He leverages his expertise and decades of experience in goal setting, relocation assistance, and investing for long-term wealth to help clients reach their full potential.