Does Automatic Dividend Reinvestment Make Sense?

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I’ve been a fan of dividend stocks for a few years now, ever since the Great Stock Market Sale of 2008 (I picked up a few more in the Less Volatile Sale of Mid-2011). With my longer time horizons and my hardy stomach for volatile stock prices, I found it easy to be patient and purchase shares in solid companies with good earnings and a dividend policy that was consistent and not overreaching. With a basket full of dividend stocks paying out once every quarter (or twice a year), one of the bigger questions on my mind was whether I wanted to reinvest my dividends.

Many brokerages now let you reinvest your dividends without charge. It’s a nice feature that was, many many years ago, only available through company-specific DRIPs. The question is whether automatic reinvestment makes sense?

Pros of Automatic Reinvestment

The biggest argument in favor of automatic reinvestment is that you’re able to acquire more shares of stock without any additional cost. If a broker charges you a fee for this, it’s probably a good reason to find a new broker (and to not use automatic reinvestment).

Another reason why automatic reinvestment makes sense is that you’re maintaining the size of your holdings. Whenever a stock goes ex-dividend, when the shareholders set to get a payout are established, the price will drop by the corresponding amount. The price falls because cash is exiting the business. With automatic reinvestment, you keep your invested amount in a company at the same level through the dividend payout. If you want to keep $5,000 in a company that pays out 3% each year, reinvestment ensures that your total invested amount is as close to $5,000 (minutes taxes on the dividends) as possible without adding new capital.

Cons of Automatic Reinvestment

The biggest argument against automatic reinvestment is that it creates a bit of a tax headache. Every time there’s a dividend and a reinvestment, you create another tax lot. Most companies that pay out a dividend will do so every quarter. That’s four new tax lots each year. Over the course of many years, these lots can add up. While you can use some shortcuts to make it simpler, and many brokers now help track this for you, it does add a bit of a headache.

In addition to the tax accounting headache, there’s a possibility that reinvestment ruins your ability to harvest losses. The wash sale rule states that in order to claim losses on an investment, you can’t buy or sell shares in that investment in the 30 days preceding and the 30 days after you sell your underwater investment. If you automatically reinvestment in a dividend stock, that creates a preciously small window in which you’re able to sell a stock and harvest it’s losses without impediment. If you do find yourself wanting to harvest and you did just reinvestment, you can still do it. You just have to adjust for the shares you recently purchased.

Personally, I reinvest my dividends but I may change that in the future. The tax issue doesn’t phase me and I like accumulating a few more shares each quarter at no extra cost.

{ 14 comments, please add your thoughts now! }

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14 Responses to “Does Automatic Dividend Reinvestment Make Sense?”

  1. DIY Investor says:

    I for one am not a fan of dividend reinvestment especially today with commission free exchange traded funds. As you point out they can present a nightmare in taxable accounts when selling because of the need to come up with a cost basis.

  2. tbork84 says:

    I agree. One way to avoid having to worry about taxes is to have your dividend reinvesting stocks in a non-taxed account. Especially with those typically being long term investment accounts, it allows for dividend reinvestment to really pay off.

  3. I think dividend investment makes sense for ETFs and index funds, but not individual stocks. DRIPs are very old school these days, and expose the investor unnecessarily to individual security risk…… not to mention the headache of keeping track of the cost basis.

  4. zapeta says:

    I’m with you Jim, I always take advantage of automatic dividend reinvestment. I’m buying quality dividend paying stocks now at good prices and I don’t plan on selling so the tax lot issue is not much of an issue for me. Eventually I will have a large enough portfolio that the dividends paid out will provide a significant income, all without selling the stock.

  5. nickel says:

    We have all our dividends paid into a money market fund and then we use that money (along with ongoing contributions) to top up whichever holding is low at the time. This helps reduce the number of tax lots, and also protects against unintended wash sales, etc.

  6. Steve says:

    I only reinvest dividends in retirement accounts for tax complication reasons. Last I checked, long term capital gains are taxed at the same or lower rate than dividends. You can still trip the wash sale rule if you have the same investment in different accounts.

    • cubiclegeoff says:

      Capital gains are taxed at the same rate as Dividends. However, money taken out of a tax-deferred retirement account I believe is taxed at your income tax rate, it is not taxed as capital gains. And for a Roth account, as long as you reach the right age, the capital gains are not taxed at all.

  7. The tax headache mentioned in the post isn’t a factor if the dividend reinvestment is happening within tax sheltered retirement plans. At a minimum, these plans would be an outstanding place to use dividend reinvestment.

  8. Kev says:

    why not just invest in a mutual insurance company like New York Life or Northwestern Mutual? I get 6.8% return with the dividend. and yet growth is tax deferred, withdraws are tax free, there’s no minimum or maximum I can put into it. And I get life insurance to boot (that increases annually)! Not to mention I have access to it tax an penalty free before 59 1/2, and no scheduled withdraws. And I reinvest the dividend to buy more life insurance which increases my annual dividend and doesnt create any year end or future tax problems! Win win win to me.

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