Paul's Insights: Cash in, invest or reinvest?

One of the things I love about shares and exchange traded funds is the potential to receive regular income through dividends or fund distributions. For retirees, these can be a valuable source of household income. But if you don’t need the cash, which can be the case if you’re still in the workforce, a reinvestment strategy can seem sensible.

On one hand, reinvesting dividends or fund distributions will ramp up the power of compounding returns. That’s because compounding is based on the concept of ‘earning returns on your returns’.

But it’s not always this simple.

Among those companies that offer dividend reinvestment plans, shareholders can typically take their dividend as cash in hand or instead, use the dividend to buy more shares in the company – often at a discounted price. You’ll save on brokerage, and at the same time follow a strategy of dollar cost averaging. So it can seem like a win-win.

The catch is that if you choose to reinvest dividends, the Tax Office will look on the arrangement as if you had received the money as cash. So the income is likely to be taxable in the financial year the dividend was paid – no matter whether it’s reinvested or not.

From an investment perspective there’s another point to weigh up.

When you reinvest dividends or fund distributions, you are putting more money into the same investment. That may be fine if you already have a highly diversified portfolio. But research continually suggests this isn’t the case for many Australians.

Unless you have a significant sum invested, the dividends or distributions you receive may not be enough to invest in other assets straight away: the minimum marketable parcel is $500. So you may need to add those regular returns to a savings account, and wait until you’ve accumulated enough money to buy new shares or invest in a different ETF. This can call for discipline. If that’s not your strong point, opting for a reinvestment plan could be the right move for you. 

Taking dividends or distributions as cash also provides opportunities to rebalance your portfolio. This is the process of adding to some investments and maybe selling down a few others, so that your portfolio mix continues to reflect your goals and how you feel about risk.

With some companies opting against paying a dividend this year as a result of COVID-19, you may not have to worry about the issue of reinvestment – at least in the short term. But it’s certainly something to plan ahead for, when dividends start flowing again.

Paul Clitheroe is Chairman of InvestSMART, Chair of the Ecstra Foundation and chief commentator for Money Magazine.