Dividend Reinvestment: What You Should Consider

Dividend Investing: How it Works

Dividends are one way for companies to return value to shareholders. Alternatively, companies may choose to reinvest profits back into the company, buy back shares or make corporate acquisitions.

Cash dividends, as the name implies, 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 one-off events.

Investors often think of cash dividends as free money. That isn’t necessarily the case. Theoretically, on the day a firm pays a dividend, the share price tends to fall 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.

Ordinary Dividends

Dividends tend to fall into one of two categories: ordinary or qualified. It is important to understand the potential differences in tax treatment between the two types. Dividends, by default, are considered ordinary, or unqualified, unless they meet special IRS requirements.

As the name suggests, ordinary dividends are taxed at the same rate as your ordinary income. Therefore, the tax rate varies depending on the recipients’ tax bracket, but is still typically higher than the corresponding capital gains tax rate.

Dividends from certain entities are automatically classified this way; 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.

Qualified Dividends

Qualified dividends are subject to long-term capital gains tax rates, which tend to be lower than rates for ordinary income. This means qualified dividends are taxable at rates of 20%, 15%, or even 0% depending on the recipients’ tax bracket.

According to the IRS, qualified dividends must come from a US company or qualifying non-US company and meet certain required holding periods for the stock. Holding period requirements vary by type of stock (common stock, preferred stock, mutual funds, etc.). For common stock, the holding period is typically 61 days; whereas, preferred stock requires holding for 91 days.

Dividend Investing Drawbacks

Importantly, dividends aren’t guaranteed. Companies can reduce or eliminate dividends at any time, especially during tough times. If you rely on dividend income for necessary expenses, you could find yourself in a difficult position.

Additionally, if you invest exclusively in 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.

A lack of diversification, less investment flexibility, uncertainty of payments and potential tax disadvantages are just some of the risks associated with investing solely for dividend income.

Dividend Reinvestment

If dividend-paying stocks play a part in your investment strategy, you need to decide how best to use those dividends. Some investors prefer to let dividends accumulate in their accounts as cash. If you don’t need cash flow from your portfolio and you believe the company’s future is bright, you might consider reinvesting the cash by purchasing additional shares.

If you decide to reinvestment your dividends, a dividend reinvestment plan may be right for you. If a dividend reinvestment program isn’t available, you may consider taking dividends as cash and then reinvesting on your own.

Another Option to Generate Cash Flow

Dividends aren’t the only way of using stocks to generate cash flow. Instead of focusing solely on dividend income, you may be better off investing for total return (price appreciation plus dividends) and creating your own cash flow strategy.

One often-overlooked way to generate cash flow is to strategically sell stocks. We call this process “homegrown dividends.” By selectively selling stocks 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 may involve modest 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 overweighted positions to maintain an optimal asset allocation.

For some investors, generating homegrown dividends could offer greater investment flexibility, potentially lower taxes, increased portfolio personalization and more consistent cash flow.

To Dividend, or Not to Dividend?

Dividends could play a role in your long-term investment income strategy, but don’t overlook the benefits of compounding growth or the flexibility of homegrown dividends. Whether you are in retirement or have many years to go before retirement, we believe a strategy focused on total return (price appreciation + dividends) gives investors the best chance to achieve their long-term financial goals.