A question from our readers:

Should I choose to have dividends reinvested or should I receive them in cash and then reinvest them myself?

A dividend is a portion of a company’s earnings paid to the shareholders. Some companies pay dividends. Others choose to spend the earnings to grow the value of the company. These two choices are equivalent from an investment perspective.

If one restaurant chain pays shareholders a 2% dividend and another restaurant chain buys commercial real estate and opens another location causing the share price to appreciate by 2%, the shareholders have been equally compensated in either case. Dividend paying companies are not superior companies. Dividend paying companies are simply one type of value company.

Mutual funds and exchange traded funds holding dividend paying stocks will also aggregate and pay dividends to their shareholders.

Dividend reinvesting is an automated service that brokers provide where instead of receiving the dividend as cash, dividend payments are used to purchase additional shares of the stock or fund that generated them.

When a dividend is automatically reinvested, it is equivalent to the cash being received and immediately used to purchase additional shares. The investor still owes tax on the dividend just as though it was received before shares were purchased. The cost basis of the new shares is calculated the same as though the shares were purchased intentionally.

Because dividends are usually small, the number of shares purchased is often a fractional number of shares.

On the one hand reinvesting dividends does not do anything that you could not do yourself. On the other hand, reinvesting dividends automatically keeps your money invested and growing in the markets.

Here are 5 reasons why we don’t automatically reinvest dividends for our managed account clients.

1. Dividend reinvestment can create hundreds of trade lots.

Every purchase in a taxable account requires keeping track of the cost basis for that specific exchange. The cost basis of the security is used to calculate capital gains and its associated tax when you sell.

If you engage in monthly dividend reinvesting, you are creating a new tax lot every month for every dividend paying security. That can create hundreds of tiny trade lots each year. Hundreds of trade lots may not be problematic in and of themselves, but they can create problems.

Trade lots are difficult accounting, although no longer for you.

In 2010, the government began requiring brokerage firms to keep track of the cost basis of each trade lot. They also require them to transfer that information to other brokerages whenever a security is transferred.

2. Dividend reinvestment can cause wash sales.

Tax-loss harvesting, where you intentionally sell securities which have a loss, saves money on taxes. To prevent abuse of this strategy, the government invented the concept of wash sales.

If you purchase the same security within 30 days past or future of selling that security for a loss, it is called a wash sale. Instead of being able to realize the loss and take it off on your taxes, the cost basis of the purchased security is adjusted by the loss of the security you sold.

Having monthly reinvested dividends makes it near impossible to engage in tax-loss harvesting without triggering a wash sale.

3. Dividend reinvestment can generate short term capital gains.

If you decided to sell a position, dividend reinvestment will almost guarantee that some of that position will have been purchased less than a year ago. The government allows capital gains on positions which have been held over a year to be taxed at a lower rate. But capital gains from positions held less than a year are called short term gains and are taxed at the higher ordinary income tax rates.

Dividend reinvestment will often stick you with short term capital gains when it comes time to sell.

4. Dividend reinvestment leaves less cash.

There are a number of cases where there is a regular withdrawal on an account. Perhaps a monthly required minimum distribution is being made. Perhaps there are charges or fees being paid. Perhaps a standard of living is being withdrawn. Allowing dividends to be paid in cash requires less trading in the account in order to satisfy regular withdrawals on the account. Less trading means less trading fees which generates savings.

5. Dividend reinvestment can accelerate portfolio imbalance.

Rebalancing can boost investment returns. But rebalancing requires investing more in those positions which have gone down or not appreciated as much. This is perhaps the most important reason to take your dividends in cash.

Dividend reinvestment invests simply in those positions which pay the most dividends. Meanwhile, paying dividends in cash makes it easier to intentionally purchase positions which best rebalance the portfolio.

For all of these reasons, we allow dividends to be paid in cash and then invested deliberately according to the planned investment allocation.

The one benefit of dividend reinvestment is that the brokerage firm usually does not charge their trading fee. This means if you are only investing in one fund, either because you are using a target date fund or because you are just starting out with investing, dividend reinvestment can save you money. However, if you have an asset allocation, you can often make more money on the rebalancing bonus than you’d save on trading costs.