Dividends, the portion of earnings that a company or fund distributes to shareholders, may seem like a relatively small component of your overall portfolio. However, dividends can play an important role in your financial success over time.
You have probably heard that it is a good idea to reinvest your dividends, and it is true that reinvestment can help your portfolio grow more quickly. However, for some investors, such as those who are retired, regular dividend distributions can provide a potentially useful source of income. The course of action that makes the most sense for you will depend on your individual needs.
Reinvesting vs. Withdrawing Cash
With dividends you have two basic options:
Reinvest for long-term growth. If you are primarily concerned with growing your portfolio over many years, reinvesting dividends might be an appropriate strategy. Because of the power of compounding, reinvested dividends have the potential to boost your return over time, assuming your investments gain in value. Automatically reinvesting has an added benefit of forcing you to stay disciplined about saving.
Withdraw as cash. If you are primarily concerned with paying monthly expenses and other cash flow needs, taking dividends in cash may be the right decision. Retirement is a particularly good time to weigh the benefits of taking your dividends in cash.
Drawing your income directly from investments can provide you with a supplemental source of cash flow if your other income sources are insufficient to meet expenses. Also, using dividends for income keeps your principal invested, potentially preserving your retirement savings.
Understand the Risks
Reinvesting dividends can have some drawbacks. By adding to your holdings in the same stock or fund, you may be increasing your exposure to that investment and therefore your risk. A growing position in a particular investment can also throw your portfolio's asset allocation off balance, which may mean incurring costs when selling shares to rebalance.
To avoid some of these disadvantages, consider setting up your accounts to deploy dividend distributions directly into a separate investment or, if you want to keep your funds available for future investment opportunities, a money market fund.
Do Not Forget About Taxes
Reinvesting dividends can also present challenges during tax time. For taxable accounts, each purchase you make with dividends must be added to your cost basis, meaning the original value of the investment when you bought it. (Inherited and gifted assets have different tax basis criteria.)
When you sell the investment, the higher cost basis is used to calculate your capital gain or loss. A careful accounting of your changes in cost basis — including increases from all of your reinvested dividends — prevents you from over- or underpaying your income taxes. None of this is relevant to your assets held in retirement accounts, because dividend reinvestments are taxed the same as your regular contributions when you begin taking distributions.
Re-evaluate Your Strategy
Bear in mind that dividends are not guaranteed, and you should be comfortable with the risks of investing in the types of assets that offer dividends. Whether you originally decided to reinvest dividends, it is worth a conversation with your financial advisor to assess whether it is still the appropriate choice for your current situation.
Wealth Management Group Newsletter – Fall 2015
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
