Dividend Reinvestment: What You Should Consider
For many investors, dividend income may sound like an attractive benefit to holding certain stocks. Some of those investors choose to receive dividends in cash. Others choose to reinvest those dividends through dividend reinvestment plans (DRIPs). Before we elaborate on the merits of dividend reinvestment, we’ll help you better understand dividends so you can determine if dividend stocks, and dividend reinvestment, is right for you.
First, and contrary to what some investors believe, it’s important to know that dividend-paying stocks aren’t necessarily safe, guaranteed or foolproof. The reality is dividend stocks, like any other stock, have risks and nuances to consider before investing. Some dividend-yielding assets might be an appropriate part of your portfolio. If so, understanding how dividend reinvestment works, and if it is right for you, are important considerations.
What is a Dividend?
When a company makes a profit, one of the ways to distribute some of the earnings to shareholders is by paying a dividend. A dividend is a voluntary distribution of earnings—or profit—from a company to shareholders. A corporation’s board of directors determines whether to pay a dividend along with the dividend payment schedule, dividend amount and format—usually cash or additional stock.
When a dividend is announced, a company also sets an ex-dividend date and a payment date. Put simply, the ex-dividend date is the day the dividend amount is subtracted from the stock’s price. To be eligible for payment, shareholders must own the stock before the ex-dividend date. As dividends are voluntary payments to shareholders, the amount and frequency can vary. Most companies pay dividends in cash, but some choose to pay dividends in additional shares of stock. The Internal Revenue Service (IRS) has specific tax guidelines for different types of dividends.
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Dividend Investing: How it Works
Dividends are one way for companies to return value to shareholders. They can also reinvest cash into the company to grow profits, buy back shares or make lucrative acquisitions. There are two main types of dividends—cash and stock.
Cash dividends are paid by the company in the form of cash. Stock dividends are additional shares the company distributes to shareholders. Both types of dividends may be recurring or only happen once. Investors often think of cash dividends as free money. That isn’t necessarily the case. The cash comes from the stock price itself. When a firm pays a dividend, the share price falls on the ex-dividend date by about the amount of the dividend, all else being equal.
This isn’t to say dividend stocks are bad, but they shouldn’t be considered automatically superior to low- or non-dividend-paying stocks.
It is also important to understand the differences between ordinary and qualified dividends along with the impact of accompanying potential tax rates. Dividends, by default, are considered ordinary, or unqualified, unless they meet special IRS requirements.
As the name suggests, ordinary dividends are taxed as ordinary income. If you get a dividend, you pay the same tax rate on ordinary dividend income as you pay on your standard federal income taxes. Therefore, the tax rate varies depending on the distribution recipients’ tax bracket, but is still typically higher than the corresponding capital gains tax rate.
Dividends from certain entities are automatically unqualified; including special one-time dividends or those paid by real estate investment trusts (REITs), master limited partnerships (MLPs), tax-exempt organizations, employee stock options, and money market accounts.
According to the IRS, qualified dividends must come from a US company or qualifying non-US company and meet the required holding period for the stock. Holding period length, determined by the IRS, varies by type of stock (common stock, preferred stock, mutual funds, etc.). For common stock, the holding period is typically 61 days for qualified dividends whereas preferred stock requires holding for 91 days.
Qualified dividends fall under long-term capital gains tax rates. This means qualified dividends are taxable at rates of 20%, 15%, or even 0% depending on the recipients’ tax bracket– often substantially lower than the income tax rates applied to ordinary dividends.
Dividend Investing Drawbacks
Dividends aren’t guaranteed. Companies can reduce or eliminate dividends at any time, especially those going through tough times. If you are relying on dividend income for necessary expenses, you could find yourself in a difficult position.
If you invest in only dividend stocks, you may end up with a less-diversified portfolio. Dividend-paying stocks tend to concentrate in sectors such as consumer staples and utilities. If these sectors fall out of favor, portfolio returns may suffer.
Dividend stocks can play an important role in your investment portfolio, but relying solely on dividend stocks has its pitfalls. A lack of diversification, less investment flexibility, uncertainty of payments and potential tax disadvantages are just some of the risks that come with investing solely for dividend income.
If you use dividend-yielding stocks in your investment portfolio, you need to decide how best to use those dividends. Some investors prefer to let dividends accumulate as cash in their accounts. If you don’t need cash flow from your portfolio, you might consider dividend reinvestment. Dividend reinvestment can benefit you by investing in additional shares and can potentially set up your portfolio for compounding growth.
Some companies may offer Dividend Reinvestment Plans (DRIPs) that allow for automatic reinvestment. If you decide to reinvestment your dividends, a dividend reinvestment plan may be right for you. If you do not wish to use a dividend reinvestment program, you may consider taking dividends as cash and then reinvesting on your own.
Another Option to Generate Cash Flow
Instead of focusing solely on dividend income, you may be better off investing for total return (capital gains plus dividends) and seeking alternative ways to generate income and cash flow.
One often-overlooked way to generate cash flow is to strategically sell stock and distribute the proceeds. We call this process “homegrown dividends.” By selectively selling stock or other securities to generate cash flow, you may be able to maintain a well-diversified portfolio with more flexibility than if you were relying solely on dividend income.
While this strategy carries the cost of trading commissions, it is a flexible and potentially tax-efficient way to generate cash flow, especially for larger portfolios. You can sell stocks at a loss to offset realized capital gains, or you can selectively pare back over-weighted positions.
For some investors, generating homegrown dividends could offer greater investment flexibility, potentially lower taxes, more portfolio personalization and cash flow that is more consistent.
To Dividend, or Not to Dividend?
Dividend income and dividend reinvestment might be a useful part of your long-term investment income strategy, but don’t overlook the benefits of compounding interest or the flexibility of homegrown dividends. Whether you are in retirement or have many years to go before retirement, we believe your focus should be on total return, of which dividends are just a part. If you focus only on dividends, you could be missing out on the best portfolio strategy for your needs.