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Why You Should Be Reinvesting Dividends

Posted By Jim On 03/15/2010 @ 12:05 pm In Investing | 21 Comments

I’ve been investing in a few dividend stocks lately because savings account rates [3] have been pretty abysmal. The prospect of earning a percent or two on my money is great for an emergency fund but lousy for anything long term.

One of the important ideas behind dividend investing is that you should reinvest the dividends if you don’t need the income. Public companies offered dividend reinvestment plans, or DRIPs, that let you buy shares directly from them and have your dividends reinvested for free. Nowadays, many brokers offer this service for free and I take advantage of them.

However, just because everyone says it’s a good idea doesn’t make it a good idea. Why should I reinvest my dividends?

The main argument, as far as I can see, for reinvesting dividends is because you get to dollar cost average additional shares at no additional cast, assuming your broker offers free dividend reinvestment (and many do). It’s recommended that you reinvest dividends because it lets you buy more of a company you had confidence in at absolutely no cost.

You still pay taxes on the dividend income. So if you do reinvest, be sure to account for the tax you owe on the dividend because the entire dividend will be reinvested. For example, I own a few shares of Costco (COST [4]) and get paid a small dividend of $0.18 a share every quarter. If I had 100 shares, I’d get $18 a quarter reinvested in the form of Costco shares. In turn, I’d owe 15% in taxes on the $18 so I need to set aside $2.70 in taxes.

If you read about the subject elsewhere, they’ll show you numbers about how reinvesting is better than not reinvesting but I think they’re unfair comparisons. If you reinvest dividends, you’re investing more of your money and so if it appreciates then you make more. If the stock falls, you lose more money. Over the long run it’s more likely that you will gain more but it’s not a 100% certainty, plenty of well-known and illustrious companies see their stock price fall to $0.

Dividend reinvestment is a great way to accumulate additional shares in a company you believe in and those shares will, in turn, pay out dividends. It isn’t, however, some sort of fancy magic.

(Photo: epicharmus [5])


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[3] savings account rates: http://www.bargaineering.com/articles/high-yield-savings-accounts-rates.html

[4] COST: http://www.google.com/finance?q=NASDAQ:COST

[5] epicharmus: http://www.flickr.com/photos/epicharmus/1613548865/sizes/s/

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