Weighing up reinvestment
A KEY issue for investors is whether to tick the box for a dividend reinvestment plan or take the money as cash.
One of the things I love about shares and exchange traded funds is the potential to receive regular income through dividends or fund distributions.
For retirees, these can be a valuable source of household income. But if you do not need the cash, which can be the case if you are still working, a reinvestment strategy can seem sensible.
On one hand, reinvesting dividends or fund distributions will ramp up the power of compounding returns. That is because compounding is based on the concept of “earning returns on your returns”.
But it is not always this simple.
Among companies that offer dividend reinvestment plans, shareholders can typically take their dividend as cash in hand or, instead, use the dividend to buy more shares in the company — often at a discounted price.
You will save on brokerage, and at the same time follow a strategy of dollar cost averaging. So it can seem like a win-win.
The catch is that if you choose to reinvest dividends, the tax office will look on the arrangement as if you had received the money as cash. So the income is likely to be taxable in the financial year the dividend was paid — no matter whether it is reinvested or not.
From an investment perspective, there is another point to weigh up.
When you reinvest dividends or fund distributions, you are putting more money into the same investment.
That may be fine if you have a diversified portfolio. But research continually suggests this is not the case for many Australians.
Unless you have a significant sum invested, the dividends or distributions you receive may not be enough to invest in other assets straight away: the minimum marketable parcel is $500.
So you may need to add those regular returns to a savings account, and wait until you have accumulated enough money to buy new shares or invest in a different ETF. This can call for discipline. If that is not your strong point, opting for a reinvestment plan could be the right move for you.
Taking dividends or distributions as cash also provides opportunities to rebalance your portfolio.
This is the process of adding to some investments and maybe selling down a few others, so your portfolio mix continues to reflect your goals and how you feel about risk.
With some companies opting against paying a dividend as a result of COVID-19, you may not have to worry about the issue of reinvestment — at least in the short term. But it is something to plan for, when dividends start flowing again.