Why You Shouldn’t Automatically Reinvest Dividends

Why You Shouldn't Automatically Reinvest Dividends

Over the past several weeks, I’ve spent a lot of time streamlining our finances. As part of this process, I went into our taxable investment account and shut off the automatic dividend reinvesting feature.

I know, I know… Dividend reinvestment makes up a huge percentage of investment gains. On top of that, I’m a big fan of automating your finances. So what gives?

To be fair, we still automatically reinvest dividends in our tax advantaged (retirement) accounts. But out in the taxable world, there are several good reasons why you should have your dividends paid to cash and then reinvest them manually.

Simplifying your records

One of the biggest reasons that I made this change is that I want to simplify our record keeping. In a taxable account, whenever you purchase shares of an investment, you generate a “tax lot” – a chunk of shares whose price needs to be tracked for tax purposes.

When you automatically reinvest dividends on an ongoing basis, you generate a small new tax lot every time an investment holding pays a dividend. Since most investments pay dividends more than once a year, and since most investors hold multiple investments, your record keeping burden can grow fast.

Let’s say you hold three different mutual funds that pay quarterly dividends. If you automatically reinvest, you’ll create three additional tax lots per quarter. If you reinvest manually, you can take the dividends from all three funds and reinvest them in just one, creating 1/3 as many tax lots.

More efficient rebalancing

As nice as it is to simplify your record keeping, an even bigger reason to manually reinvest dividends is that it can save you a nice chunk of change on taxes when it comes to rebalancing your portfolio.

Inevitably, your asset allocation will get out of whack over time and you’ll need to rebalance. In essence, this involves selling some shares of the investment that is over-represented in your portfolio and buying more of whatever investment happens to be under-represented.

In retirement account, this is a no-brainer. Just sell one and buy the other. There are no tax consequences. But in a taxable account, selling your “winners” can generate capital gains, which means you’ll have to pay taxes. While your dividends may not be enough to keep your portfolio in check, you can minimize shares sales when rebalancing by directing your dividends toward your laggards.

For example, let’s say that you’re shooting for a 60/40 mix of stocks and bonds, but your stocks have been outperforming your bonds over the past year or so. As your dividends are paid on all investments in your taxable account (both stock and bonds), simply gather them up and buy more bonds.

Avoiding wash sales

Finally, when the market is down, many investors engage in something known as “tax loss harvesting.” Here’s how it works…

Suppose you’ve invested in a certain mutual fund, and the price has tanked. Assuming that this is an investment you want to hold for the long term, you might be inclined to sit tight.

Instead, you might consider selling your shares to book that loss so you can take advantage of your bad luck at tax time. Now that you’ve locked in your loss, however, you don’t want to miss out on a possible rally, do you? So the next question is… How soon can you buy back in? This is where the “wash sale” rule comes in.

The wash sale rule requires that an investor wait at least 31 days after selling a security for a loss before repurchasing the same security, or a “substantially identical” investment. If you buy back in within 30 days, the IRS will treat it as if you never sold in the first place, and you’ll lose the ability to claim a loss.

The IRS also treats it as a wash sale if you make a purchase within the 30 days before the sale of your downtrodden shares. Thus, if you buy more shares in that 60 day window centered on the date of the sale, whether intentionally or via dividend reinvestment, you will generate a wash sale.

If this happens due to dividend reinvestment, all is not lost. The occurrence of a wash sale doesn’t invalidate the entire tax loss harvesting maneuver. Rather, you will just lose the ability to claim a loss on the number of shares that you repurchases within that window.

Regardless, if you’re at tax savvy investor, you can avoid this complexity by manually reinvesting your dividends. Either direct them to an investment other than the one that you’re harvesting, or hold onto them until you’re outside the wash sale window.

Is manual dividend reinvestment right for you?

Above, I’ve outlined three good reasons to suspend automatic dividend reinvestment in your taxable accounts, but… Should you really do it? As with most things, the right answer depends on you.

For example, if you’ll be tempted to spend your dividends, or if you’re concerned that you’ll never get around to manually re-investing them, then you may want to continue with automatic reinvestment. But if you’re disciplined, manual reinvestment can streamline your record keeping and reduce your tax bill.

Another consideration, brought up in the comments by a reader named Tom is that you can sometimes save on transaction costs by using automatic reinvestment. That is, if you have to pay a fee to make “normal” purchases (like buying Vanguard funds at Fidelity, or buying stocks through a broker), you should check to see if automatic reinvestment is free. If it is, then switching to manual reinvestment could cost you.

20 Responses to “Why You Shouldn’t Automatically Reinvest Dividends”

  1. Anonymous

    I offer the following for feedback…

    1. If you reinvest distributions in a fund that has high payout each year you will be taxed on the distribution in that year thereby reducing your real return.

    2. In the above example, if you reinvest distributions you increase the number of shares thereby increasing the tax in future years as the distributions are based on the number of shares.

    3. If you limit the number of shares by no longer reinvesting (taking them in cash and reinvesting in a fund or ETF with no or low distributions), you limit future taxes.

    4. Assuming you will not need to sell the shares during your lifetime, the basis is subject to a step-up to the value on the date of death. Therefore why not limit the growth of the fund?

    5. I realize one could simply sell the fund and invest in one with low or no distributions. Unfortunately, in my case there is a significant gain which would be taxable as LT Cap Gains.

    Bottom Line – For the above example, I suggest:
    – Do not reinvest distributions.
    – Take distributions in cash and reinvest in a fund or ETF with no or low distributions.

    What say you???

  2. Anonymous

    With the new IRS cost basis reporting rules that require transfer agents and brokers to track and report cost basis for shares acquired after Jan 1 2011, 2012, and 2013 depending on the security type purchased it will make DRIP investing easy because whenever you do sell your cost basis will be reported right on your 1099B

  3. Anonymous

    The calculation is easy. Each year do the following:
    1. Numerator: Add the balance in all of your IRA accounts using the prior December 31st balance.
    2. Denominator: Find out what your “factor” is for the year. It changes depending on your birth date.

    Divide the numerator by the denominator and that is your required minimum distribution (“RMD”) for that year. You can take out more than the required, but if you take out less, the difference is subject to a 50% annual penalty. You can take the RMD from any of your IRA accounts

    It usually makes no difference what you paid into the IRA originally. The rare exception is for some people who made non-deductible contributions in the IRA. The calculation of the RMD is the same. It only affects how much is taxable.

  4. Anonymous

    Congrats on your advanced degrees. I am not as knowledgeable as I’d like, and just came across your website. I have an IRA spread out across 8 different mutual funds. It isn’t a Roth IRA. When I retire in ? years, won’t I have to pay tax on the earnings at that time? How will I know what the cash basis is on the individual divident reinvestments …and will it be a nightmare for me? I don’t think I will be in a financial position to pay someone to figure it out for me. Any advice?

  5. Anonymous

    Apologies if this is a silly question, but if you automatically reinvest dividends doesn’t that mean you are tied to reinvesting those dividends in the company at that point in time and therefore at that share price in time (which might be inflated). If you pooled dividends and reinvested manually you could pick your entry point and potentially make/save a lot of money, i.e. get more shares for your money.

  6. Anonymous

    I just went through looking at my investments over the years. I have always reinvested my proceeds. However, a lot of the value has gone down. If I would have taken the dividends and not reinvested, I would be about $100,000 more in the green. I am not going to reinvest anymore. I am nearing retirement and am tired of playing the game, thinking I’m getting something that I am not.

  7. Anonymous

    Your not a simpleton. I see a lot of smart people get caught up on “free” (or low cost) dividend reinvestment without realizing that it may require a lot of bookkeeping. And it gets worse if the stock splits.

    When I say “cash poor” I am referring to people who have many non-cash assets but have little in cash. They are afraid to sell their stocks because they have no idea what their cost basis is to compute the eventual tax, so they just eke by. You’re right, they could (and probably should) turn off their dividend reinvestment but that will not give them a big infusion of cash. Today I am working on an estate plan for a man with ~$1 million in stock but no idea of the cost basis. He needs major work on his house but is afraid of selling the stock.

    As for being a “pain for a CPA later on” if I need to spend the time researching cost basis instead of preparing four or five other tax returns, who do you think I’m going to charge for that extra time?

  8. Anonymous

    Maybe I am just a simpleton but Jea, how could losing track of what they reinvested years ago make anyone cash poor:

    1) They could turn off the dividend reinvestment tomorrow and receive their dividends
    2) They would still be as “cash poor” if they pooled the money.

    Reasons #1, 2 and 3 make sense but #4 doesn’t. You just hit sell all in most discount brokers…will it be a pain for a CPA later on? Yup but the equities will be sold.

  9. Anonymous

    I am a CPA with an accounting degree from one of the best schools in the country. Later I became an attorney and do estate planning and income taxes. I see a lot of people who are asset rich but cash poor because they lost track of how much they reinvested years ago. Plus I noticed that many of the companies are now charging for reinvesting their dividends. My recommendation is to let the dividends pool up and buy stock directly.

    #1. You can pick the same company or another company. Just because a company is paying a dividend does not necessarily mean it is a good company to keep investing in.

    #2. Cost basis records are much easier even if your broker is keeping the records for you. I have seen broker mistakes.

    #3. If you use a discount broker, the cost to buy a new stock is minimal.

    #4. Selling stock in a brokerage can be done almost instantly. Selling stock held in a reinvestment plan can take time depending on the company and may require extra work.

    Bottom line – I will not do dividend reinvestment except in an retirement account (IRA, etc.) where cost basis is not an issue.

  10. Anonymous

    Another thing to note is if you are buying stock through an Employee Stock Purchase Program (ESPP), the dividend might be re-invested at market price. I buy shares through my employer’s ESPP, where employees pay a price that is a certain % below market price per share, but automatic reinvestment of dividends is done at market price. Therefore, if you want to reinvest at the lower price, you must manually reinvest the dividend by increasing your pay deduction. Just some food for thought…

  11. Evan: I originally wrote the article assuming that people are investing in no-load mutual funds, which is clearly an oversimplification. A few hours after publication (roughly 24 hours ago), I updated it to add the final paragraph to indicate that if you are paying for your transactions, and if auto-reinvestment is free, then you should probably keep doing it.

    As for need to rebalance and avoid wash sale problems… By directing your dividends to the “right” investment, you can minimize the tax implications of rebalancing. You may still need to do it, but you won’t have to sell and buy as much. And for wash sales, sure, you still have to avoid running afoul of the 30 window, but this is much easier to do when you have to willingly place a trade vs. having them happen in each and every investment automatically.

  12. Anonymous

    You are throwing away money just for a little of work later on? At between 5 and 12 a trade (depending where your accounts are) that could purchase a tiny fraction of a share which then can buy a tiny fraction of a share, etc. (i.e. compounding) just so you don’t have to cCreate a spreadsheet/Download one EASILY from your broker. The other 2 reasons you mentioned you’ll have to do no matter what. Regardless of whether your re-investing dividends automatically or purchasing shares later on you’ll still have rebalancing issues and you’ll still have to avoid wash sale rules.

  13. Jim: Yeah, it’s pretty straightforward if you sell your entire position. But if you want to pick and choose, dividend reinvestment can make a real mess out of things.

  14. Anonymous

    I had dividend reinvestment for a stock I owned for about 13 years. Every quarter I’d get a little more stock via the dividend reinvestment. When I sold it I had to figure out the cost basis to report the taxes. It ended up with a excel spreadsheet with 60 individual entries for each purchase over the years. Fortunately however when you report the sale to the IRS all you have to do is add up the sums and report it as one large lot.

    The instructions for schedule D say: “”if you sold a block of stock (or similar property) that you acquired through several different purchases, you may report the sale on one line and enter”VARIOUS” in column (b).” But you do have to split up short term and long term purchases.

    So for tax reporting purposes its not as hard as I would have thought. In fact since the brokerage account gives me an Excel sheet download all I had to do was download the records, sum the columns and threat it as a single purchase/sale item.

  15. Tom: You’re absolutely right. If you have to pay a fee to invest (such as buying Vanguard funds through Fidelity) then automatic reinvestment might save you a bunch of money b/c reinvestment is free whereas additional purchases cost. I’ll update the article.

    BG: This has never been Vanguard’s strong point. They’ve historically tracked your average basis, which is easy, but not good for advanced tactics like tax loss harvesting, or minimizing gains when you sell. There have been some recent changes in cost basis tracking requirements, so it will be interesting to see if Vanguard improves in this area.

  16. Anonymous

    This is without a doubt the most thorough article I have ever read about this topic.

    One note about wash sales; they can also be triggered buy buying the same securities in a different account. Furthermore if the other account is a tax-advantaged one, the ability to claim the loss goes away permanently. Technically the wash amount is added to the basis of the position, except that in a tax-advantaged account the basis is not used to determine tax.

  17. Anonymous

    I enjoy this blog, but I’ve never commented before. Just wanted to say that I found this interesting, but I think you left out an important point. In some cases (this is true for me; I use Fidelity) automatic reinvestment of dividends is free while making normal purchases incurs a fee. I think your readers may want to be aware of that.


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