What Are the Consequences of Reinvesting Dividends?
As a stock investor, you own a percentage of the company you invested in, including a percentage of the company's earnings. Paying dividends is one way many companies can share earnings with stockholders. Choosing to reinvest your dividends can significantly improve the performance of your investments over time, but can make calculating your taxes a bit more complicated.
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Income vs. Growth Tradeoff
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Choosing between taking the cash or reinvesting your dividends is a decision between future growth potential and income. If you are retired or nearing retirement age, earning an income from your investments may be more important than increasing your wealth. On the other hand, if you do not need an income in the near future, reinvesting your dividends allows you to buy more shares, compounding your long-term investment returns.
Compounded Returns
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The average dividend paid by companies that pay investor dividends is between 3 and 4 percent per year, according to Seeking Alpha. This may not sound like much, but it can really add up. For example, assume you invest $10,000 in a company that grows at an average rate of 7 percent per year and pays a 3 percent dividend. If you choose not to reinvest your dividends, in 35 years, your stock will be worth $106,765. Had you reinvested your dividends, your stock would be worth $281,024, or more than double.
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Keeping Track for Uncle Sam
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Dividends are taxed during the year you receive them, while capital gains are not taxed until you sell your stock. To determine your capital gain, you need to know your cost basis, or the price you originally paid. Dividends are usually paid each quarter, which means you will have multiple costs to calculate during the year you sell your stock. Keeping a record of all your purchase prices can make calculating your total cost basis much easier.
Dividend Taxes
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You have to pay tax on your dividends during the year you receive them, regardless of whether or not you reinvest them. The rate of tax you pay depends on how long you own the stock. If you sell the stock within 60 days of the dividend payment, your dividends will be taxed at your regular tax rate. As of 2011, if you hold the stock longer than 60 days, your dividends will be taxed at 15 percent if you are in the 15 percent tax bracket or higher. If you are in a lower tax bracket, your dividends will be taxed at 5 percent.
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