Getting a Dividend Because Cash Is Overrated – Do This Instead | Personal Finance

(Stefon Walters)

There are two primary ways to make money from a stock: an increase in the share price and dividend payments. The first is simple: you buy stocks at one price and hopefully sell them for more in the future. Dividends are not that simple and their contribution to an investor’s total return can be underestimated. But as of 2021, dividends accounted for about 32% of the S&P 500total return since 1926.

Companies generally pay dividends from their profits, so younger companies tend not to pay dividends because they reinvest their profits to stimulate growth. However, more established companies will offer a regular payout to offset less growth potential and entice investors.

If you are invested in a dividend-paying stock or fund, you can receive your dividend in cash or enroll in your broker’s dividend reinvestment program (DRIP) if it offers one. A DRIP takes all dividends paid out and automatically reinvests them in the stock or fund that paid it out. And if you have the opportunity, you should strongly consider going the DRIP route.

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Add to the effects of compound interest

Compound interest occurs when the money you make from your investments starts making money on its own. Thanks to compound interest, if a stock yields 10% annually, a one-time investment would increase in value more than 10 times in 25 years. Compound interest is one of the biggest phenomena in investing, and you can magnify its magic by reinvesting dividends instead of taking them as cash.

Let’s say you invested $1,000 monthly in a fund with a fixed dividend yield of 2.5% that yielded an average of 10% per year over 25 years. Here’s how the account totals would differ if you took the cash dividends instead of reinvesting them:

Reinvesting dividends? Account total after 25 years
no $1.18 million
Yes $1.72 million

By reinvesting the dividends, you benefit on two fronts. First, increase the number of stocks you own over time and remember that each stock (or fraction of one) will continue to enjoy a 10% return every passing year based on the above scenario. But in addition, since dividend payments are based on the number of shares you own, you also increase your total dividend payments over time.

Keep your eyes on retirement

The real difference between taking dividends as cash and reinvesting them happens at retirement. If you can accumulate a significant amount of dividend-paying stocks, they can be a great source of retirement income. It may not be enough to fund your retirement on your own, but it can be a substantial addition to your other sources of retirement income, such as a pension and Social Security. If you can collect $1 million in dividend-paying stock with an average return of 2%, that would be an additional $20,000 you can collect in passive income.

One of the best ways to save for retirement while taking advantage of dividends is to use a Roth IRA if you qualify. Roth IRAs allow you to invest money after tax and then enjoy tax-free withdrawals upon retirement. Usually, dividends received in cash are taxed at your capital gains rate, but if it’s in a Roth IRA, you don’t have to worry about that. Using a DRIP to add to compound interest and then receive tax-free payouts in retirement is a win-win for investors.

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