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Dividend reinvestment can be a real boon to investors, especially within an individual retirement account, where you're protected from certain tax consequences. Inside an IRA, you can reinvest your full payout, compounding your portfolio faster than if Uncle Sam takes a bite of each dividend. Reinvesting your dividends can be very simple, too. Most brokerages allow you to set up an automatic plan that reinvests the full amount of any dividend back into the stock or fund that paid it.
But is it always smart to reinvest your dividends? Here are the three questions you need to ask yourself to see whether you should automatically reinvest your IRA dividends.
» Read more: How to invest in dividend stocks
1. What is your time horizon?
Dividends are like any money that you’re going to invest: They need time to compound and wait out the short-term vagaries of the stock market. So if you don’t have a long time horizon before you need the cash, it might be better to not reinvest it, at least not automatically.
Financial advisors recommend you give any money you put into the market at least three to five years to grow. So like your ongoing investments, your reinvested dividends need to be able to hit that mark, too. In the end, cash is cash, and it all needs to be invested properly.
Do you have more than three years before retirement? Reinvest away! You want that money compounding as soon as possible. The longer you have it working for you, the better off you’ll likely be. And if the market does dip in the short term, you won’t even remember it when retirement rolls around. Time will likely have turned that dividend into even more money (and dividends).
2. Are you taking IRA distributions, or plan to take them soon?
If you’re already taking distributions on your IRA, or you plan to in the next year or two, then it doesn’t make sense to reinvest your cash. Over the short term the market can do almost anything (namely, plummet), and if you’re required to take IRA distributions or simply need the money, it’s awful to reinvest your dividend and then watch a market downturn shrink it.
If your time horizon is short, it’s better to hold the dividend in cash. Or if you need a bit of return on those dividends without the volatility of the stock market, you could drop those dollars into a short-term bond fund. But remember even bond funds can go down, and the only 100% safe investments are cash and FDIC-insured bank deposits such as savings accounts or CDs.
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3. Do you want to reinvest your dividends manually?
Part of the brilliance of reinvesting dividends automatically is that the brokerage will reinvest the full amount into the stock or fund at no cost, even buying fractional shares. You get to compound the full amount and save a commission, too. Saving that commission is especially valuable when you’re just starting out investing, so automatic reinvesting makes a lot of sense early on.
Those who are more experienced in the ways of the stock market may want to reinvest manually, though, especially if they’re buying individual stocks. Individual stocks are more volatile than the market as a whole, so sharp investors may be able to reinvest dividends when a stock is cheaper, leading to potentially even better returns than automatic reinvesting. This way costs more time and money (trade commissions) than having it done automatically, though.
Manual reinvesting is not for everyone, and if you’re not willing to commit time to the market, you’ll likely do much better with automatic reinvestment. Just put it all on autopilot and enjoy life.
One final point
If you’re trying to compound your dividends and maximize your retirement savings, your choice of IRA can help. With a traditional IRA, you pay taxes on your gains when you take distributions, so the dividends pile up tax-free for a while, but the taxman eventually gets a cut. However, with a Roth IRA, you’ll never pay taxes on the dividends when you take qualified distributions, making it a favorite with many dividend investors. There are other advantages to each account, though, so you’ll want to examine which account is best for you.