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Does Automatic Dividend Reinvestment Make Sense?

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 [3]. The wash sale rule [4] 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.