Most investors know that dividends are essential because they provide them with extra cash. One of the best uses for dividends is to let them grow into enormous sums by reinvesting them—that is, use them to buy even more shares of stock that also pay dividends.
Learn how dividends add extra earning power to your existing investments.
- One of the best uses for dividends is to let them grow into enormous sums by reinvesting them—that is, use them to buy even more shares of stock that also pay dividends.
- Generally, when you receive dividends, you have to pay taxes on them, even if you reinvest them.
- The one limitation of reinvesting dividends is that you forgo the use of the dividends over a long period.
- However, if you can afford to continue reinvesting returns throughout your working years, the benefits can compound into a comfortable lifestyle once you decide to stop working.
Reinvesting Dividends Creates Growth
In Jeremy Siegel’s book, The Future For Investors: Why the Tried and True Triumph Over the Bold and the New, you'll find some interesting figures:
Between 1950 and 2003, IBM grew revenue at 12.19% per share, dividends at 9.19% per share, earnings per share 10.94%, and sector growth of 14.65%. At the same time, Standard Oil of New Jersey (now part of Exxon Mobile) had revenue per share growth of only 8.04%, dividend per share growth of 7.11%, earnings per share growth of 7.47%, and sector growth of negative 14.22%.
Knowing these facts, which of these two firms would you rather have owned? You may be surprised.
A mere $1,000 invested in IBM would have grown to $961,000, while the same amount invested in Standard Oil would have amounted to $1,260,000—nearly $300,000 more. The oil company’s stock only increased by 120-fold during this period; IBM, in contrast, nearly tripled Standard Oil's profit per share.
The performance difference comes from dividends. Despite the much better per-share results of IBM, the shareholders who bought Standard Oil and reinvested their cash dividends would have over 15 times the number of shares they started with. In contrast, IBM stockholders had only three times their original amount.
How Reinvesting Dividends Works
The choice to reinvest your dividends can make a huge difference when examining a single firm. Say you decide you want to put $100,000 into one of the world's biggest medical, pharmaceutical, and consumer product blue-chip stocks, Johnson & Johnson.
Reinvesting dividends purchases more shares, giving you more earning power in the long run.
Having gone public in 1944, the heirs of the company's founding family were listed among the wealthiest Americans on the first Forbes 400 list in 1981. It had long been considered one of the premier blue-chip stocks in the market, and you believe it's as good a choice as any.
You buy the stock, paying $2.8281 per share. What happens? Consider the two alternatives.
One alternative is that you decide not to reinvest dividends. Your $100,000 grows into $4,367,897 before taxes. This consists of:
- 35,359 shares of Johnson & Johnson at a market price of $93.39, for a total market value of around $3,302,177
- Aggregate cash dividends of around $1,065,720
Another cause for celebration is that if they were to have a dividend rate of $3.00 per share, you are set to collect $106,077 in dividend income over the coming twelve months.
Note that it takes a significant number of shares to generate income from dividends. This is why it is a long-term strategy—purchasing shares from reliable dividend-paying companies is costly.
The other alternative is that you decide to reinvest dividends. Your $100,000 grows into somewhere around $7,062,245. This consists of 75,621 shares of Johnson & Johnson stock at a market price of $93.39
Due to your significantly higher share count—almost double the stock—you are set to receive $226,863 in dividend income over the coming twelve months.
Those seemingly small dividend checks did that. By reinvesting dividends, you ended up with $2,694,348 in surplus wealth from the capital gains and dividends generated on the shares purchased with your original dividends.
Tax Benefits of Reinvesting
Generally, when you receive dividends, you have to pay taxes on them, even if you reinvest them. However, domestic corporations' dividends are taxed at the capital gains tax rate, which is lower than normal income tax.
At specific thresholds of modified adjusted gross income, dividends can trigger the net income investment tax of 3.8% on either the investment income or the amount over $250,000 (married filing jointly) or $200,000 (single), whichever is less.
Net investment income tax added to capital gains tax is still less than ordinary income tax at that level of income.
Fewer investment taxes means more money to place into your investments, compounding their growth capability even further.
The Limitations of Reinvesting
The one limitation of reinvesting dividends is that you forgo the use of the dividends over a long period. If you invested for 33 years, this is money you could have used for other purposes.
However, if you can afford to continue reinvesting returns throughout your working years, the benefits compound into a comfortable lifestyle once you decide to stop working.