Dividend reinvestment can be a real boon to investors, especially within an individual retirement account (IRA). That’s because the tax advantages of an IRA allow to reinvest your dividends without paying taxes, which can help your portfolio grow faster.
Although it can be a simple way to grow your account, is it always the right choice? Here are four questions to answer before automatically reinvesting IRA dividends.
1. What is your time horizon?
Like any money you plan to invest, reinvested dividends need time to compound. Some financial advisors recommend allowing giving money you 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 at least three to five 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
2. Are you taking IRA distributions, or do you plan to take them soon?
If you’re already taking distributions from your IRA, or if you plan to begin doing so in the next year or two, then it might not make sense to reinvest your dividends. Over the short term, the market can do almost anything (namely, plummet), and if you have to take required minimum distributions or simply need the money, it’s hard to reinvest your dividends and then watch a market downturn shrink your account.
If your time horizon is short, consider holding dividends 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.
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3. Do you want to reinvest your dividends manually?
With automatic reinvesting, brokerages use your dividend to purchase more of the stock or fund. They typically do this at no cost, even when buying fractional shares. So, automatic reinvestment allows investors to compound their dividends and save on commissions. It’s especially valuable for new or hands-off investors who want to grow their balance.
More experienced investors, particularly those who buy individual stocks, may prefer to reinvest dividends manually. Individual stocks can be more volatile than the market as a whole, so active investors may want to reinvest their dividends when prices are lower, potentially leading to better returns than what they might get with automatic reinvesting. However, this method costs more time and money (trading commissions) than automatic reinvestment.
Manually reinvesting IRA dividends is not for everyone. If you’re not willing to commit time to it, you’ll probably do better with automatic reinvestment.
4. 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 tax collector eventually gets a cut.
- 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.
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