(Stefon Walters)
There are two main ways to make money on a stock: an increase in the share price and the payment of dividends. The first is simple: you buy shares at one price and hopefully sell them for more in the future. Dividends are not that simple and their contribution to investors’ total return may be underestimated. But as of 2021, dividends accounted for about 32% of the S&P 500‘s total returns since 1926.
Companies generally pay dividends out of their profits, so younger companies tend not to pay dividends while reinvesting their profits to fuel growth. However, more established companies will offer a regular payment to offset lower growth potential and attract investors.
If you’re invested in stocks or funds that pay dividends, you can receive your dividend in cash or sign up for your broker’s account. dividend reinvestment program (DRIP) if offered. A DRIP takes the dividends paid and automatically reinvests them in the stock or fund that paid them. And if you have the option, you should seriously consider going the DRIP route.
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Add to the effects of compound interest
Compound interest occurs when the money you earn from your investments begins to make money on its own. Thanks to compound interest, if a stock yields 10% per year, a single investment would grow more than 10 times in value in 25 years. Compound interest it’s one of the biggest phenomena in investing, and you can add magic to it by reinvesting dividends instead of taking them as cash.
Let’s say you invested $1,000 per month in a fund with a 2.5% fixed dividend yield that returned, on average, 10% per year for 25 years. Here’s how the account totals would differ if you took the cash dividends instead of reinvesting them:
| Reinvest dividends? | Total account after 25 years |
|---|---|
| Nope | $1.18 million |
| Yes | $1.72 million |
Reinvesting dividends allows you to benefit on two fronts. First, increase the number of shares you own over time, and remember that each share (or fraction of a share) will continue to enjoy a 10% return with each passing year under the scenario above. But beyond that, since dividend payments are based on the number of shares you own, it also increases your total dividend payments over time.
Keep your eyes on retirement
The real difference between taking cash dividends and reinvesting them occurs in retirement. If you can build up a sizable number of dividend-paying stocks, they can be a great source of retirement income. It may not be enough to fund your retirement on its own, but it can be a substantial addition to your other sources of retirement income, such as a pension and Social Security. If you can accumulate $1 million in dividend paying stocks with an average 2% yield, that would be an additional $20,000 you can collect in passive income.
One of the best ways to save for retirement while reaping dividend benefits is to use a Roth IRA if you’re eligible. Roth IRAs allow you to invest money after taxes and then enjoy tax free withdrawals in retirement. Cash dividends received are generally taxed at the capital gains rate, but if it’s a Roth IRA, you don’t have to worry about that. Using a DRIP to add compound interest and then receive tax-free payments in retirement is beneficial to investors.
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