Many investments can pay dividends – stocks, mutual funds, index funds, exchange traded funds to name a few. Owners of these investments have to make a choice as to what will happen to the dividends. Dividends can be taken in cash or reinvested.
Cash dividend option
Dividends can be taken in cash which leads to different possibilities:
- The money will be mailed to your house or deposited into your bank account. This is a good option if you are using the money to supplement your income. This option is usually only available in taxable accounts. Keep in mind that these dividends are taxable income so depending on your tax situation, you might have to keep a cash reserve for taxes.
- The money will stay in the investment account. This option is normally chosen by an investor who doesn’t need the income from their investments just yet. The investor can use the cash to buy different investments than the one which produced the dividend.
Reinvest dividend option
A different option is to reinvest the dividend. Any dividend stays in the investment account and is used to buy more units or shares of the investment that produced the dividend. Dividends in a taxable account are still considered taxable income – even if they are reinvested.
- Mutual funds – Most mutual funds automatically reinvest any dividends to buy more mutual fund units unless the investor asks to receive the dividend in cash.
- Stocks - Dividend stock investors sometimes like to use their dividends to buy more shares of their favorite stocks. Similar to compound interest, dividends can help increase the value of your investment. A DRIP is where you can buy a dividend stock and then use the dividends to continuously buy more stock.