If you’ve ever found yourself asking whether it’s better to reinvest dividends or take cash, you are not alone. It’s a commonly asked question when choosing to invest in shares.
The answer lies in your own personal strategy and financial situation. No one person is the same, however there are a range of advantages and disadvantages to how you choose to use your dividends.
Here we aim to explore in a little further detail whether you should reinvest dividends (in more shares, via a dividend reinvestment plan) or whether you should take the cash earnings and use it to repay your mortgage, credit card or simply act as an additional source of income.
The basics: How does a dividend reinvestment plan work?
Quite simply, a dividend is a portion of the companies profits – paid out to shareholders in the form of cash or option to reinvest in more shares. If you need a deeper explanation, I suggest you do some searching online – but this summary is essentially all you need to know.
Dividends are normally a percentage, which is applied to the amount of shares you own. So for instance, a dividend from a major bank is usually 3% – meaning if you hold $5,000 worth of shares – your dividend will be around $150. As most banks allow dividend reinvestment (DRPS) – you can choose to take the $150 in more shares. Simply divide the $150 by the current share price and that is how many shares you will receive.
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Alternatively, you can choose to have the $150 paid to your nominated bank account in cash. So which is better?
Is it better to reinvest dividends in more shares? Or is it better to take cash and use the money elsewhere?
Advantages of reinvesting dividends (in more shares)
You don’t pay brokerage fees (saving around $30)
Using the $150 dividend example, $30 equates to an extra 20% you would have to pay if you chose to buy those shares outside of the dividend reinvestment scheme. This adds up over time, especially considering the next point.
You compound your initial investment (shares on shares on shares as I say)
Each time you reinvest your dividends in more shares, your holding size grows. This means the next time you get a dividend, it’s been calculated on a larger holding. This is a great example of compounding returns – give yourself 20+ years and the compounding effect will be significant.
As Albert Einstein said:
Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t…pays it.
It’s a perfect set and forget investment strategy
Opting to reinvest dividends in more shares is an easy set and forget strategy to diversify and grow your wealth. The vast majority of Australian’s don’t invest in shares – but you do – and if you reinvest dividends, you are growing your net worth on auto pilot.
It forces you to save money
Similar to the above, another benefit of reinvesting in dividends is that it simply forces you to save. While “save” may be the wrong word to use here – it is forcing you to get ahead, much like a mortgage forces you to regularly chip away at your principle on a property.
Disadvantages of reinvesting dividends (and why you may want to take cash)
You may have a lower income, thus the dividends could help boost your household earnings
Depending on the size of your share portfolio, dividends can provide a great source of income on a regular basis (often half yearly). This means the dividends you earn, can be paid to you in the form of cash, which you can use as additional income to achieve things like:
- Paying down your mortgage faster
- Paying off credit card debit
- Supplementing your primary income
- Contributing to education costs for kids and more
While taking dividends in the form of cash won’t grow your share portfolio, it may contribute and act as extra income to achieve the above. It really depends on your goals. For instance, I have recently purchased a new house which means my mortgage is now my number one priority – it’s making me wonder whether I should take cash and make lump sum repayments to my mortgage to bring it down faster. While there are people who will debate either side, in terms of what is a better return, it comes down to what helps you sleep at night.
It creates a little more work at tax time
Not really a disadvantage in the modern day given most share investing websites provide free tax summaries, however reinvesting dividends does require you to report any earnings to the ATO.
The price you acquire shares via dividend reinvestment is set by the market
Another issue some people have with dividend reinvestment plans is that the share price is set by the market, meaning when you earn your dividends – it will buy shares using that money based on the current market rate of the shares. Some people prefer to selectively pick and choose the time to buy.
The verdict: take cash or reinvest dividends?
Assess your goals to decide; remember, if your share portfolio is relatively small, weigh up whether a few hundred dollars per year taken in cash is going to truly help.
If it isn’t going to help much, consider reinvesting the dividends and experience the 8th wonder of the world.