Automatically reinvesting your dividends shouldn't be for everyone.
Reinvesting your dividends to keep growing your portfolio is always a smart move. That's why many big dividend stocks offer dividend reinvestment programs, or DRIPs, which automatically reinvest your dividends into more shares of the company. Many brokers have made it easy to set up automatic dividend reinvestments for your stocks as well.
But dividend reinvestment programs aren't nearly as useful in the age of free stock trades as they were when you used to have to pay your broker a minimum fee for each trade you made. You can invest as little as $1 in fractional shares with no additional fees with a lot of brokers. So, the benefits of a DRIP have been erased.
In fact, there may be downsides to using a DRIP to reinvest your dividends. Here are three reasons not to.
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1. You'd rather use your dividends to pay for expenses in retirement
If you plan on using the dividends your stock portfolio distributes to pay for your living expenses, then you don't want to reinvest your money in stocks. You want cold hard cash.
Setting up a portfolio of big dividend payers and then living off the dividends in retirement is a great way to establish generational wealth. If you can live off the dividend payments and never have to sell your stocks, then you can pass on that stream of income to your heirs. What's more, you'll usually cap your tax liability at the qualified dividend tax rate.
While you might use a DRIP to accumulate as many shares of your dividend stocks as possible while you're working, you need to turn off the faucet once you reach retirement. So, be sure you set things up to start receiving cash once you retire.
2. You want to select your best stock investing opportunities actively
If you're using a DRIP, the money automatically gets reinvested in a stock no matter what price it's trading at. But if you're actively researching multiple stocks, you may see better opportunities to deploy new cash.
While shares of Apple, for example, may not be anything to sneeze at, you may not want to buy more shares of the tech giant right now. Instead, you may be looking at shares of another tech company with a good dividend like Microsoft, which offers a higher dividend yield and may trade at a better valuation, in your opinion.
Importantly, even if you only own 10 shares of Apple and receive a whopping $2.30 per quarter, most brokers will allow you to buy a fractional share of Microsoft to reinvest those dividends at no cost. The increased availability of $0 fee trades has removed one of the biggest benefits of DRIPs.
3. You want more control over your asset allocation
If you're maintaining a diversified portfolio, dividends flowing into your account provide an opportunity to rebalance. Instead of reinvesting in the same asset, you can use the dividend payment to buy assets that have fallen in value relative to the rest of your portfolio.
This applies for individual stock investors as well. You may not want any single stock to become too heavily weighted in your portfolio. But if you have a company that pays out a hefty dividend, it could become a much bigger portion of your portfolio than you intended after several years.
Even if you take the cash and then decide to reinvest back into the same asset, there's no additional cost to do so. By purposefully directing where you reinvest your dividends instead of automatically buying back the same shares, you'll be able to benefit most from your asset-allocation decisions.
A DRIP can be a great way to automatically reinvest your cash payments and help maximize the growth in your portfolio. But if you take a slightly more active role in managing your portfolio, you can do better than using a DRIP.
Adam Levy has positions in Apple and Microsoft. The Motley Fool has positions in and recommends Apple and Microsoft. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.
