2 Reasons to Reinvest Dividends

September 30, 2015 — Leave a comment

Quiz!

What is the financially optimal way to handle stock dividends for a retiree?

  1. Automatically reinvest the dividends and sell from the principal for income.
  2. Keep the dividends in cash and use them for income.

Look for the answer below and read this month’s article for a discussion.

2 Reasons to Reinvest Dividends

In recent years, it has become tougher to automatically reinvestment dividends. Despite this difficulty, it is still beneficial.

What is the difficulty with automatically reinvesting dividends? When reinvesting dividends (as with any other “buy” trade), there is a 61-day window (30 days before and after the reinvestment) in which selling and recognizing tax-losses is disallowed. This is called the “Wash Sale Rule”, and is established to prevent people from selling and buying for the pure sake of getting a tax deduction. Complying with the wash sale rule, requires knowing the date of upcoming dividends at least 31 days in advance, to avoid sales in that window.

How has it become more difficult to automatically reinvest dividends? Brokers & custodians are required to report the cost basis of mutual fund purchases on form 1099-B, in order to shed light on wash sales, and discourage them. By not reinvesting dividends, you reduce the number of buys, including the number of wash-sale windows, and retain more freedom to sell without violating the wash sale rule.

What are the benefits of reinvesting dividends?

1. Full participation in gains: Reinvested dividends never stay in cash, allowing you to get the investment returns at all times, and avoid missing returns while money sits in cash. For every 1% that you avoid keeping in cash in the account, and instead keep in an investment that averages 10% per year, you get a benefit of 0.1% per year (1% of 10%). This is a material portion of the investment performance.

2. Tax deduction: When there is a need for cash (e.g. retirement income) or a rebalance, you can sell the most appealing mutual fund shares (outside the 61-day wash-sale window), allowing to realize tax losses.

How can you avoid wash sales? To avoid wash sales, you need to be strategic, and sell away from the time of dividend reinvestments. Dividends are often given quarterly. After excluding the month before and after the dividend, you are left with one month per quarter to sell while realizing tax losses. One strategy is to sell once per quarter (whether for rebalancing or for withdrawals). If you need cash throughout the quarter, you can choose between keeping it on margin (borrowed against the brokerage account) if the amount is small, or selling in advance for large amounts.

Quiz Answer:

What is the financially optimal way to handle stock dividends for a retiree?

  1. Automatically reinvest the dividends and sell from the principal for income.  [The Correct Answer]
  2. Keep the dividends in cash and use them for income.

Explanation:  While keeping the dividends in cash is the easiest thing to do mechanically, there are many benefits to reinvesting them. The article above explains the benefits.

Disclosures Including Backtested Performance Data

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Gil Hanoch

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