Should retirees reinvest their dividends?

Dividend reinvestment can be a lucrative option for retirees as long as they have other sources of short-term income. In fact, dividend reinvestment is one of the easiest ways to grow your portfolio, even after your earning years are behind you.

However, it isn't the best strategy for everyone. You'll want to carefully examine your current financial situation and future needs before choosing this investment option.

Dividend reinvestment is the practice of using dividend distributions from stock, mutual fund or exchange-traded fund (ETF) investments to purchase additional shares. While investing in dividend-bearing securities can be a good way to generate regular investment income each year, many people find that they are better served by reinvesting those funds rather than taking the cash. 

"Investors should keep reinvesting their dividends after retirement since most dividend payments are not substantial enough to warrant any immediate use by the investor," says Mark Hebner, founder and president of Index Fund Advisors in Irvine, Calif.

If you receive $500 each year in dividends but earn $50,000, for example, those dividend earnings don't make a huge difference to your yearly income. If you consistently reinvest those dividends each year, you can grow your portfolio without sacrificing any additional income. Reinvesting dividends is one of the easiest and cheapest ways to increase your holdings over time.

There are two ways you can reinvest dividends: either by taking the cash and purchasing additional shares through your broker or by using an automatic dividend reinvestment plan (DRIP).

Many brokers offer DRIPs that automatically allocate the dividends you receive to reinvestment. Your dividend distributions are used to purchase additional shares of the security – often at a discount.

Unlike purchasing additional shares the traditional way, dividend reinvestment plans allow you to purchase partial shares if the amount of your dividend payment is not enough to purchase full shares. If the current price of a given stock is $20, for example, a dividend payment of $30 would purchase 1.5 additional shares. If you reinvested manually, you would only be able to purchase one additional share and take the $10 in cash. A few extra bucks in your pocket may seem like a good deal, but the buying power of $10 is unimpressive compared to the potential earnings generated by increasing your investment. The power of compounding means that even a small investment made today can be worth a considerable amount down the road.

Dividend reinvestment can be a powerful tool for retirees. Retirees have spent years building their portfolios, so the amount of dividend income they receive each year can be considerable. By reinvesting those earnings even after retirement, you could continue to grow your investment so that it can provide even more income down the road when you may have exhausted other income streams.

"Historically, the total return of the S&P 500 has delivered just over nine percent per year. About half of that total return has come from price appreciation and half from dividends," Hebner explains.

What could your earnings be? "Based on historical estimates, somewhere around 4.50 percent per year for someone with a long time horizon," Hebner says.

If you have planned well for retirement, you may have savings squirreled away in several different accounts, between investment portfolios, individual retirement accounts (IRAs) and 401(k) plans. If so, you may find that you have enough saved to keep you comfortable without taking your dividend distributions as cash.

In addition, most retirement savings vehicles require that participants take a minimum distribution by a certain age. If you're required to withdraw from these accounts after retirement anyway, and the income from those sources is sufficient to fund your lifestyle, there is no reason not to reinvest your dividends. Earnings on investments held in Roth IRAs accrue tax-free, making dividend reinvestment especially lucrative.

If you are lucky enough to be in this position, reinvesting dividends in tax-deferred retirement accounts and taxable investment accounts offers two major benefits. It can extend the period over which your retirement accounts will provide income, and it can also ensure that your taxable accounts provide a healthy source of funds once your retirement accounts are exhausted.

Shares purchased with reinvested dividends in a taxable account likely carry a different cost basis than original shares, since share prices change over time. Employing a professional tax accountant can help you avoid errors in calculating your taxable investment income at tax time.

Many people don't have the kind of earnings history that enables aggressive investing. If you aren't as well-prepared for retirement as you would like, reinvesting your dividends can certainly help you bulk up your portfolio during your working years. However, after retirement, you may find that dividend distributions provide a much-needed income stream.

Another situation in which dividend reinvestment may not be the right choice is when the underlying asset is performing poorly. While all securities experience ups and downs, if your dividend-bearing asset is no longer providing value, it may be time to pocket your dividends and think about making a change. If the security value has stalled but the investment continues to pay regular dividends that provide much-needed income, consider keeping your existing holding and taking your dividends in cash. Over the long term, companies or funds that are unable to generate positive returns for extended periods are likely to reduce or suspend dividends.

Reinvesting dividends over the long term certainly helps grow your investment, but only in that one security. Over time, you may find that your portfolio is weighted too heavily in favor of your dividend-bearing assets, and it is lacking diversification. If you think it's time to rebalance your assets to hedge against potential losses, consider taking your dividends in cash and investing in other securities.

Careful portfolio management is not just for the young, even if you primarily invest in passively-managed securities. Keep a close eye on your dividend-bearing investments to assess which strategy is most beneficial. Reinvesting dividends in a failing security is never a smart move, and an unbalanced portfolio can end up costing you if your primary investment loses value.

Of course, your financial goals may change over time. While dividend reinvestment may be the right choice early in your retirement, it may become a less profitable strategy down the road if you incur increased medical expenses or begin to scrape the bottom of your savings accounts.

If you're lucky enough to have amassed a substantial amount of wealth, dividend reinvestment is almost always a good strategy if the underlying asset continues to perform well. If you play your cards right, you may even be able to leave a substantial nest egg behind for your family or other beneficiaries after your death.

Don't approach dividend reinvestment with a set-it-and-forget-it mentality. While DRIPs make reinvestment virtually effortless, continue to keep an eye on your investment to ensure that you're not automatically doubling down on a losing bet.

If you can afford it, consider enlisting the aid of a professional financial advisor. A trusted financial advisor can help ensure that your dividends are put to the best possible use, give you guidance regarding which investments are best suited to your individual goals and help you avoid common investment pitfalls, such as escheatment and improper asset allocation.