This year, I joined a number of other bloggers in the Grow Your Dough Throwdown, an investment challenge. In this challenge, each of the participants starts with $1,000. We can’t add any new money to the account throughout the year, but we can buy and sell as we see fit, and earnings from our investments can be reinvested.
For a long time, I’ve wanted to put together a dividend portfolio to start working on my passive investing. I decided that my challenge portfolio would less about winning the whole thing (which requires more risk than I’m comfortable with) and more about using this as a way to build a dividend portfolio.
So far, it’s been a fun experiment, and I’ve been committed to reinvesting the dividends because, during the growth phase of your income portfolio, you can build value and future dividends faster if you reinvest.
Advantages of Dividend Investing
Dividend investing is a great approach because it’s about more than capital appreciation. With dividend investing, you receive regular income from the shares you hold.
Dividend stocks and dividend funds pay out regular money to shareholders. It’s meant as an incentive to attract and retain investors. Plus, regular payouts can be an indication that a company is healthy enough that it can afford to share some of its profits with its shareholders.
This means that you receive extra income on top of any capital appreciation you might enjoy with your investment. During times of economic turmoil, healthy companies are likely to continue paying out dividends.
There are some companies, called “dividend aristocrats,” that have increased their dividends at least once a year for 25 consecutive years. Some of the companies on the list have been increasing dividends for more than 40 years. Investing in dividends can be one way to boost the overall ROI of your portfolio.
Reinvesting Your Dividends
One of the best things to do with your dividends, though, is to reinvest them. When you first start with dividend investing, you probably won’t see a huge amount of income. However, you can put those dividends to good use. Repurchase shares (or fractional shares) of your investments to grow your portfolio.
There are two main ways to reinvest your dividends:
- Buy something with your accumulated cash. For my challenge portfolio, I can’t automatically reinvest dividends, so I have to wait until I accumulate enough cash to buy new shares. So far this year, I’ve earned $30.50 in dividends, which was enough to buy three shares of another dividend investment that was quite cheap. I make it a point to buy an additional share of my cheapest dividend investment as soon as I have enough cash to do so.
- Use DRIPs. My preferred method of reinvesting my dividends, though, is the use of DRIPs. Dividend reinvestment plans automatically take your dividends and buy shares and partial shares in the company. Many companies, like Coca-Cola (KO), offer DRIPs. There are also dividend funds that offer DRIPs, and some online brokerages, like Betterment, that will automatically reinvest your dividends. This allows you to grow your wealth without having to think about reinvesting your dividend earnings.
Dividend reinvestment is basically getting free shares (and partial shares) of an asset. You don’t have to put more of your own capital into the investment, since the dividend is a payout from the company. This makes it very easy to boost your portfolio growth. Over time, if your investments grow in value, having the extra “free” shares can really pay off.
Plus, the more shares you own, the higher your dividend payout is, so your dividends grow as well. Then you can buy more shares, and the cycle continues. If you consistently add money to your account through dollar cost averaging on top of your dividend reinvestment, things can really pick up.
It’s vital that you understand this. During the growth phase of your portfolio, even small amounts reinvested can help. Over time, consistency in reinvestment can add up as compound interest works behind the scenes to multiple your investment.
For tax-advantaged accounts, this can be a big deal. If you have the dividend investments in a Roth IRA, you won’t be taxed on your dividend income at all.
Be wary of using dividend investments in a tax-deferred account, though. While you won’t have to pay taxes until later, the withdrawal will be taxed at your marginal rate. Right now, dividends are taxed at a favorable rate, so it might not make sense to defer your taxes. In fact, some recommend that you even keep your dividend investments out of the Roth, if you have other assets that are taxed at higher rates in there.
When deciding where to keep your dividend investments (and where you reinvest the dividends), think about the long-term tax consequences.
Also, pay attention to the latest tax news. Even though dividends are taxed at a more favorable rate now, that could change. Realize, too, that even if you reinvest your dividends, and you don’t see the actual cash in your hands, you still have to pay taxes on your dividend earnings. It’s a lower rate, but unless you keep your dividend investments in a Roth account, you still need to pay taxes on your earnings.
Even if you don’t keep your dividend investments in a Roth IRA, or even a tax-deferred account, you can still benefit. In seven to 10 years, you might have grown your portfolio enough to see significant regular income. This can be a real boon later if you want to use that income for something. However, you shouldn’t expect to see big income from dividends, unless you have a large chunk of capital to invest. Like most other forms of dollar-cost averaging, dividend reinvestment is about the long haul, and building your portfolio consistently over time.
As you plan your investing strategy, consider including dividend reinvestment. With the right strategy and the right attention to taxes, dividend reinvestment can boost your returns now and later, and provide you with a solid way to get ahead.