To reinvest a dividend means that rather than receiving a dividend in cash, you elect to receive an equivalent value of additional company stock.
Dividend reinvesting is a strategy to compound dividend payouts by accumulating additional stock over time.
As always, a simple example helps...
A simple example
Let's say you have 100 shares of AT&T, which right now is worth $19.55/share and pays a $1.11 dividend/share per year which (divided by four) is ¢27.75 per quarter per share (yes they can pay fractions of a penny). You can find that information out simply on Yahoo!. Fun fact: I worked on the original Yahoo! Finance project to deliver delayed stock quotes over the internet.
Your 100 shares give you $27.75 in dividends. You could take that $27.75 in cash, or you could take a little over 1.4 additional shares ($27.75 / $19.55).
Taking the shares, your next quarterly dividend would increase from $27.75 to $28.14, or a 1.4% increase from quarter to quarter. We're not talking break the bank money here... but do this quarter after quarter and it starts to add up.
Most importantly, you're not likely to miss the $27.75 in your daily life, but keep reinvesting it and it adds up. It's a good way to keep your spending modest, while investing for your future.
The pros and cons of reinvesting dividends
There are some considerations, mostly around bookkeeping, that aren't all positive when it comes to reinvesting dividends. But first, the argument for reinvesting.
Reinvesting dividends: the pros
- It's fun! Seriously, this is important because anything fun is something you'll keep doing. It's fun watching your dividends increase quarter-after-quarter.
- If you're just getting started, you dividend payments aren't going to be very large, so you won't really miss them. I promise though, when you look back over time, you'll see how they accumulated as new investments and be impressed. Here's a quote from a reader on just that point:
I was doing my taxes over the weekend. I’ve been investing in dividend stocks for the past say year and a half. And in 2016 I got a total of about $500 in dividends. Which was surprising. Imagine doing this over many years? I can see that snowball effect really coming through.
Reinvesting dividends: the cons
Disclaimer: I'm not a tax expert, but the following will give you a good sense of the general tax parameters that you're dealing with when earning dividends from investments.
- Dividends are taxable, even if you receive them as stock. If you take the dividend as extra stock, you need the cash (from somewhere else) to pay those taxes. The federal dividend tax rate is, I believe, 20%. So it really isn't that much if you're just getting started with dividends.
- There's paperwork. Each reinvestment has to be accounted as a purchase of stock, and you have to track your cost so that when you sell you know how much you've grown. Example time. In our AT&T example, we had $27.75 in dividends so that's what's known as the cost basis* for the 1.4 shares we got instead of cash. Later on, if AT&T is at $50/share and we sell those 1.4 shares, we'd get $70 and have made $70 - $27.75, or $42.25 on which we'd have to pay capital gains taxes. You have to track each dividend reinvestment as a separate purchase. The good news is, and this wasn't the case when I wrote my book, brokerages track this automatically for you these days so there really isn't anything extra you have to do.
- Not all brokerages support dividend reinvesting, and some of those that do don't support fractional shares*. Let's break that down. The first half of that sentence is simple – call your brokerage and ask if they support reinvesting dividends. If they do, turn them on (you might have to do this for each dividend paying stock you own). Let's look at the second half of that sentence - the part about fractional shares. Notice in my AT&T example above we got 1.4 additional shares of AT&T. That 0.4 shares are a fraction of a full share. Some brokerages would only support the whole share portion - and you'd get 1 full share, and the balance in cash. It sounds more complicated than it is, my advice would be to find a different brokerage, like Fidelity or Schwab who I believe fully support fractional dividend reinvesting. If you're just starting out, I highly recommend Stockpile (that's a link to my review) as they're designed for just this sort of investing. If Stockpile's not your thing, I recommend Fidelity most. But neither of those recommendations are affiliate recommendations, they're just products I prefer.
Conclusion
I was talking with one of my readers who had a few dividend paying stocks in her IRA, but didn't know about reinvesting dividends. She had accumulated the dividends over a few years, and the cash was just sitting in the account because she didn't think much of it. It wasn't really enough cash to have an impact on her portfolio, but it always bothered her that it was sitting there not working for her future.
She turned on dividend reinvesting and got excited about her portfolio in a whole new way.
Reinvesting dividends is a great long-term play on dividend paying stocks. Want to learn more? Check out my book (including the reviews) on Amazon.
Jargon explained
I used some jargon above, and I hate doing that, it's just... well, it's jargon for a reason. Let me explain a couple of things in more detail for those who are new to investing.
- Cost basis. This is a fancy way of saying the cost of an investment. Why the need for a fancy way, why can't we simply say 'cost'? Well... let's say I buy $100 of AT&T stock. My cost is $100. But, my cost basis might be $107.00, if there were a $7 commission to make a stock purchase. So the cost basis includes all other costs around the investment beyond the actual price of the investment. This is of course a simplified explanation. If you want more, there's always wikipedia.
- Fractional shares. A long time ago, you had to buy shares in round-lots (bundles of 100) or you'd pay huge commissions. Electronic brokerages, I believe e-Trade was the innovator, started to break that barrier down, and allowed individuals to purchase single shares for very low commissions. Today, it's even possible to buy parts of a share, or fractional shares. Take Apple for example. It's trading over $200/share right now, meaning, to buy a share of Apple you need $200 ($218+ to be exact). What if you only have $100 to invest? Does that mean you can't participate in owning Apple? In the past, yes. Today, you can buy fractional shares and purchase $100 worth of Apple. Not on all brokerages, but both Stockpile and Fidelity support this. The same happens with reinvested dividends. Not all brokerages would support the fractional portion of the reinvestment. You need to ask before setting up your account, because when you are just getting started, that fractional share portion of the reinvestment is going to mean a lot.
