Dividend reinvestment can be a powerful tool as it takes advantage of two factors: time and compounding. However, you may be wondering how to go about actually reinvesting any dividends you receive in a timely and efficient manner. The best way to do so is through a dividend reinvestment plan. Through this, you can simply leave your money to be invested by a broker and let time do the rest to increase that sum’s value.

How does dividend reinvestment work?

A dividend reinvestment plan is an automatic system set up between an individual that is interested in investing their funds and a broker. The broker, as part of the plan, takes the dividends earned from investments and immediately uses them to buy more shares of an underlying investment without having you step in at every point to make a decision. If one intends to hold onto their funds for a long period of time, this is a good idea.

An important aspect to remember in this respect, however, is that when a broker makes a transaction based on the dividend reinvestment plan discussed, they may charge a transaction fee or commission of some kind for their expertise in reinvesting your funds.

Benefits of a dividend reinvestment plan:

Dividend reinvestment plans allow shareholders to collect a larger number of shares without having to pay additional commission. Through dividend reinvestment, some companies offer a 1 to 10% discount on a share price. Therefore, taking into account the discounted share prices and no additional commission, the cost basis for the shares itself is lower than if they were bought through another method.

Additionally, through automatic dividend reinvestment, compounding plays a major role. As dividends increase, the shareholders can continue to buy more shares and increase the returns on their initial investment.

When should you opt for a reinvestment plan?

There are certain factors to take into account before choosing to invest in a dividend investment plan:

Short term investments
When it comes to investing in liquid funds for a short duration, a dividend reinvestment plan is ideal since liquid funds pay dividends every day or every week, depending on the plan.

Tax bracket
If you’re in a high tax bracket, it’s best to reinvest your dividends instead of paying tax on them instead of continuously paying tax on them and reducing your investable capital.

Debt funds and a high tax bracket
If an individual chooses to invest in debt funds for a short duration of time, it would in turn attract taxes based on their income bracket. This means that if one were to be part of the 30% tax bracket, they would end up actually paying only approximately 28% instead of the entire 30%.

Dividend Reinvestment Strategies

There are a number of strategies one can revert to when deciding how to reinvest dividends. As discussed above the first method is that of automatic dividend reinvestment through a broker, let’s have a look at some other methods:

Timing it according to the market
After dividend payments are deposited into a brokerage account and cash is accumulated, the money is used to purchase more shares in the same vein as the dividend that paid well so far, or the funds are used to purchase a completely different set of shares in a security that is trading at a lower price. By purchasing these shares at a lower market value, the investor is able to achieve a higher cost basis. Any dividends received in this method are therefore immediately reinvested to create further dividends.

Index Funds
Index funds are a kind of mutual fund or ETF (exchange traded fund) which track the broader performance on the stock market, i.e. an index such as the NIFTY 50 or the S&P 500. While Index funds don’t pass dividends through investors, they can be grown using the dividends earned through a previous investment. Research has even found that index funds can provide higher returns if dividend reinvestment is taken into account.

For retirement
A retirement plan with dividend reinvestment may be a good decision for you if you do not plan to use any of the amount earned until retirement. The further advantage to this plan is that income tax is not paid on the same until money is withdrawn from the account.

At the end of the day, it is clear that reinvesting dividends is a good idea, no matter the strategy chosen. This is especially true if one plans to hold on to their shares for a longer period of time and the amount earned through the same need not be used immediately. The next time you ask yourself, “how do I reinvest dividends?” look no further, it’s an easy step to start the process while time takes care of the rest.