Should You Auto-Reinvest IRA Dividends?

Dividend reinvestment can be a real boon to investors, especially within an individual retirement account (IRA). That's because IRAs offer certain tax advantages, including reinvesting your full payout and compounding your portfolio faster than if Uncle Sam takes a bite of each dividend.

Reinvesting your dividends can be simple, but is it always the smart choice? Here are some questions you need to ask yourself to see whether you should automatically reinvest your IRA dividends.

What is your time horizon?

Like any money you plan to invest, dividends that you reinvest need time to compound. Financial advisors recommend allowing any money put into the market at least three to five years to grow. If your time horizon is short and you need the cash, it may not be ideal to reinvest your dividends immediately.

If you have three to five (or more) years before retirement, reinvesting may be a great way to get that money compounding as soon as possible. The longer that your money is in the market, the longer it has to weather any short-term dips and recover if and when the market does too.

» Read more: How to invest in dividend stocks

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 might not 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 hard to reinvest your dividend and then watch a market downturn shrink it.

If your time horizon is short, consider holding the dividend in cash. Or if you need a bit of return on those dividends without the volatility of the stock market, you could think about dropping those dollars into a short-term bond fund. But remember, even bond funds can go down.

» Check out the best IRA account providers

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.

More experienced investors, particularly those who buy individual stocks, may prefer to reinvest dividends manually. 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. But this method costs more time and money (trade commissions) compared with having it done automatically.

Manual reinvesting is not for everyone. If you’re not willing to commit time to the market, you’ll probably do much better with automatic reinvestment. Consider just putting it all on autopilot while you enjoy life.

Do you want a Roth or traditional IRA?

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. That means as your account balance grows over the years, through contributions, compound interest, and dividend reinvestment, the taxman eventually gets a cut.