As an investor, you’ll eventually need to make all sorts of decisions — and some will be difficult. But there’s one choice you can make that can be relatively easy: reinvesting stock dividends.
It’s simple to reinvest dividends — you just need to sign up for a dividend reinvestment plan (DRIP). Once you do, you won’t receive dividends directly as cash; instead, your dividends will be directly reinvested in the underlying equity. Be aware, though, that you may incur a fee when reinvesting dividends.
By doing some research, you can find companies that have not only consistently paid dividends year after year but also increased those dividend payments regularly. (Keep in mind that companies are not obligated to pay dividends and can reduce or discontinue them at any time.)
By reinvesting dividends, you may be able to realize some key benefits. First, you’ll be building your share ownership, which can help you build wealth. No matter what the market is doing, adding shares can be beneficial — but may be especially valuable when the market is down. When share prices are low, reinvesting dividends — which don’t typically fluctuate with share price — can help boost your investment reach further, simply because each reinvested dividend can buy more shares than at the previous higher share price.
Consider this: It took investors 25 years to recover from the Crash of 1929 if they did not reinvest their dividends — but it only took them 15 years to recover from the crash if they did reinvest dividends, according to Ned Davis Research. And we’ve seen the same phenomenon in more recent years, too. Since 1987, according to Ned Davis Research, we’ve had three major market corrections: Black Monday in 1987; the bursting of the dot-com bubble from 2000 to 2002; and the bursting of the subprime and credit bubbles in 2008. The S&P 500 rose following those market corrections. Investors who stayed invested during those corrections had the opportunity to participate in rising markets. Those investors participating in a dividend reinvestment plan may have been able to buy more shares at a lower price. Of course, past performance doesn’t guarantee future results and the value of your stock shares can fluctuate, including the loss of principal.
While reinvesting your dividends clearly can be beneficial, you do have to be aware that, even if you aren’t receiving the dividends as cash, you will be taxed on them. But the dividend tax rate remains quite favorable — if you’re in the 25%, 28%, 33% or 35% brackets, your dividends will be taxed at 15%. If your taxable income is more than $400,000 (or $450,000 for couples), your dividend tax rate is 20%. If your adjusted gross income is $250,000 or more (for married couples filing jointly) or $200,000 or more (if you’re single), you’ll also have to pay a 3.8% Medicare tax on your dividends.
While taxes are a consideration when investing, they should never be the driving factor. Consider also that investing in dividend-paying stocks does carry some risk — specifically, the value of your investment may fluctuate, causing you to lose some, or all, of your principal. But you may be able to reduce the impact of this possible volatility by sticking with quality stocks as part of a diversified portfolio. As we’ve seen, reinvesting dividends can help you build your investment portfolio — so consider putting this technique to work in your investment strategy.