Jun 20, 2022
When it comes to saving for the future, there is usually no shortage of advice and opinions regarding dividend reinvestment and growth investment. This article explores these two different methods of investing so that readers are able to figure out which might be best for their specific situation.
Just remember, you can use the information below as a starting point to find the investments that fit your personal needs and goals best.
Dividend Reinvestment (DR): This is simply the method where you buy and hold shares in a dividend-paying stock, such as a stock that pays out $1 per share and has $10 per share invested in it. This will often produce more income than growth investment since you are literally reinvesting your dividends into new shares of the same dividend-paying stock that pays out the same amount each quarter.
Dividend Growth (DG): This is simply the method where you buy and hold shares in a dividend-paying stock, such as a stock that pays out $1 per share and has $10 per share invested in it. However, the DR is reinvested into another stock or ETF but the payout from this second investment will grow due to compounding returns from either simple interest or reinvested dividends.
The basic reason someone might choose DR over DG is for the more immediate income of having all your money in one company. The basic reason someone might choose DG over DR is for having investments that will produce income for many years to come on compounding returns.
Interest: In a DR investment, one will collect dividend income each quarter. This can also include special dividends that might be paid out in addition to the normal monthly or quarterly distributions.
Interest is usually a good thing and this is why DR can be better than DG. At least the money is not just sitting idly by in the company's bank account where it earns nothing – instead, it is being reinvested into the same stock so that you are able to collect more dividends each quarter.
Costs: The biggest argument for DR over DG is how much you might pay in fees for using your money and then paying for reinvestment as well as dividends that are reinvested. Most retail brokerages charge commissions on trades of individual stocks or ETFs. You can find out the rates at your brokerage by looking up its commission schedule or using a site such as Commission Center.
Mortgage Payments: This might seem like an odd benefit for DR over DG but it should be considered since investors can typically qualify for a lower mortgage rate based on the amount of available equity in the company's portfolio.
Taxes: Investors will have to pay income tax on dividend and interest income each quarter. This is true regardless of the reinvested dividends (DR or DG) so long as they are reinvested into another stock that is held in the same account.
Out-of-Pocket Costs or Take Home Pay: When using DR, one must buy additional shares of their initial investments to continue reinvesting this money. While a typical investor will only have to buy 50% or less of its value each time, there is still an amount that has to be paid from one's pocket just to make the purchase.
With DG, one will usually NOT have to reinvest their dividends because this money could either be used for other expenses or simply taken out of their account as cash.
Dollar-Cost Averaging (DCA): This is the practice of investing an equal dollar amount into stock at regular intervals over a period of time. DCA can allow an investor to buy more shares during times when the price per share is lower as compared to buying at "peak" prices and not having enough money in reserve.
Dollar-Cost Averaging is the key reason why DG can be better than DR. If a company is able to produce $1 in income for every $1 invested, the average cost of investing in this company will be $0.50 since you will never have to spend more than $1 for it. As well, as long as you are able to buy 100% of your shares at some point, then your share price will always be equal to what you bought them at.
Leverage: DG investors have to make sure they know the limitations and risks of using leverage in buying stocks with borrowed money. The most common form is margin trading where a broker lends you money for buying shares in an account and then collecting interest on the borrowed amount. Of course, this also has its benefits as well since it can be used to make a quick purchase of a stock while it is currently experiencing massive volatility in price.
Taxes: Income tax might be the same for DR and DG investments. It all depends on what kind of securities you are investing in and whether their dividends are qualified or unqualified. A qualified dividend means that it is put into the 10% tax bracket while an unqualified dividend means it is put into the 15% tax bracket. You can use this to determine how much you will be able to reinvest your money since you will have to pay income tax on any dividends regardless of whether they are being reinvested or not.
Note that if you receive interest on your money, this too is taxable so both forms of investing can have equivalent tax rates for equivalent investments.
Out-of-Pocket Costs or Take Home Pay: DCA is a great way to invest in stocks because it allows investors to buy more shares when prices are low. This can be a good way to reduce out-of-pocket costs or increase the number of dividends you get over time.
The problem with DCA is that you will have to make regular investments wherever you do it (i.e. through Betterment, Wealthfront, your local bank, etc.) and then the act of receiving dividend income might force you to make another investment whether you have enough cash on hand or not.
While investors have some control over this, it is important to note that they do not have as much control when investing in DR since you will not have the option to buy your shares on their own terms.