How to choose whether to reinvest dividends or use them as income
How to reinvest dividends
When you receive dividends from the stocks you own, you have two options:
1. Treat the dividends as income.
2. Reinvest the dividends to buy more shares of the same stock.
Dividend Reinvestment Plans (DRIPs) are available for many stocks, allowing you to purchase more of the same shares by reinvesting the dividends instead of depositing cash into your checking account.
DRIP plans are beneficial for small investors, as they allow the purchase of fractional shares.
Not all companies offer this option, and not all investors choose to reinvest, even when it’s available. The right choice for you depends on your short-term and long-term financial goals.
What happens when you don’t reinvest dividends?
When you don’t reinvest dividends, you increase your annual cash income, which significantly impacts your lifestyle and choices.
For example, suppose you invested $10,000 in shares of XYZ company, a mature and stable company, in 2000. This allowed you to buy 131 shares at a price of $76.50 per share.
In this case, you do not reinvest the dividends.
By 2050, you own 6,288 shares as a result of stock splits. They are now trading at $77.44 per share, or a market value of $486,943 for your entire position. Over those 50 years, you also received dividend checks totaling $136,271. Your $10,000 turned into $613,214.
Although it’s not enough to replace a full-time income, your dividends in this scenario will provide a substantial amount of money. They can be used for emergencies, vacations, education, or simply be an addition to your regular income.
In the end, you will own $486,943 in stock in your brokerage account. This money can generate significant additional income from dividends. It can also be a large part of your retirement income.
What happens when you reinvest dividends?
When you reinvest dividends, you forfeit the additional cash flow that could have benefited your daily life. However, you benefit from larger compounding. As you reinvest the dividends, they buy additional shares as well, which in turn generates additional dividends, and all of this can be reinvested too.
Let’s return to our earlier example. In 2000, you invested $10,000 in XYZ shares. You bought 131 shares at a price of $76.50 per share.
This time, you chose to reinvest the dividends.
By 2050, your 131 shares have transformed into 21,858 shares. Due to the company’s increased value, your shares’ market value is $1,700,000. You retire and start receiving an annual cash dividend of $42,000.
In this scenario, rather than enjoying additional income over 50 years, you defer the use of money from your investments until you retire. At that time, your initial investments are worth nearly $2 million, which can fund a very comfortable retirement.
Is it better to reinvest dividends or not?
Would you prefer to enjoy over $136,000 in cash along the way? This could allow you to cover unexpected expenses or take vacations with your family. However, you could still end up with investments worth a significant amount. Would you prefer to live more frugally for most of your life but have $1,700,000 and substantial annual dividends in retirement?
The correct answer depends on your financial situation. It also depends on your short- and long-term goals, your personality, and your need for cash. If you’re earning a comfortable income and don’t feel the need to upgrade your lifestyle, reinvesting dividends to fund your retirement might be the best option for you.
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The other side, what if you need a little extra income to supplement your salary? Or what if you want to enjoy more experiences during your youth (or for your family while your children are young)? In this case, it may be best to use your dividend payments throughout your life.
In this case, you will eventually end up with nearly $500,000 in your brokerage account and the annual income from those dividends.
The right choice for you also depends on your level of risk tolerance. In the best case, you can maximize the value of your investment by reinvesting the dividends. But if the company goes bankrupt or the stock market crashes, you could lose your investment at a time when you need it most – without even getting a chance to enjoy the benefits of dividends along the way.
Ultimately, whether you reinvest the dividends or spend them, you should use your money and investments as tools to provide the highest possible balance of enjoyment and security throughout your life.
Frequently Asked Questions (FAQs)
How can you reinvest dividends if you aren’t receiving enough to purchase a full share?
Most DRIP plans allow you to reinvest any amount of dividends, so it doesn’t matter whether the dividend amount adds up to a full share or not. If you receive $1 in dividends and the share price is $10, you will reinvest $1 at that price to purchase 0.1 share.
How can I stop reinvesting dividends?
It is very easy to stop reinvesting dividends just as easy as it is to start reinvesting them. Just go to the “Dividends” section on your brokerage settings page and change your preferences. This process may not be identical across all brokers, but you will find a button in your settings that allows you to receive dividends in cash instead of shares.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we fact-check and maintain the accuracy, reliability, and quality of our content.
Investor.gov. “Direct Investing.”
New York State Office of the Attorney General. “Understanding Common Investments: Stock.”
Source: https://www.thebalancemoney.com/reinvest-your-dividends-357355
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