The power of compounding

Albert Einstein called compounding the 8th wonder of the world. It's a powerful force multiplier for dividends when those dividends are reinvested.

Let's unpack that.

Reinvesting dividends

When you receive a dividend, you can take it in cash. Or... you can have that dividend reinvested back into the original investment you've made.

The advantage of reinvesting it is that the next dividend payment is paid on your original investment PLUS all the reinvested dividends. Reinvesting dividends are like rolling a snowball downhill and watching it grow without doing any work. With each subsequent dividend payout being larger than the one before it. That's what's meant by compounding your dividend payouts.

Two considerations when reinvesting

The government considers reinvesting as two transactions, the first is receiving the dividend, the second is investing the dividend.

This impacts taxes in two ways:

1. Receiving the dividend. This is a taxable event. When you're getting started, it's probably a relatively small amount and not really impactful (in terms of putting away money to pay the taxes on dividends). However, if you manage to accumulate a larger portfolio, taxes on dividends are 20% and you should make sure that you put aside money for those taxes, and possibly even pay estimated taxes. Definitely consult a tax advisor.
2. Investing the dividend. This investment becomes the cost basis used to determine how much tax is owed when you sell the shares. Most brokerages are going to calculate this for you these days, so there's probably nothing you need to do except be aware that this is how it works.

In fact, my most popular post ever (over 22,000 readers!) was an e-book / slideshare that talked about how taxes impact the way we think about dividend reinvesting. Even though it's a powerful way to accumulate wealth over a long time horizon, tax considerations force us to NOT realize some of the benefits. I encourage you to read it yourself. It's short:

Getting raises

In my book, I take care to consider human emotions and use metrics that help to motivate investors, even when the market is going down. One of those metrics is looking at how many raises you get each year (it's 5).

Reinvesting your dividends so they compound gives you a raise – meaning, each subsequent dividend is greater because you're reinvested. And, if you're investment raises their dividend (as dividend aristocrats do annually) that's another raise for a total of five (since most companies pay dividends quarterly).

These raises compound over time, and it's a small thing to reinvest your dividends, but a powerful one if you have a long time horizon ahead of you.