One investment strategy a stock investor may use is to reinvest any earned dividends into more shares of stock. A reinvestment plan may be a formal dividend reinvestment program offered by a company to accumulate shares of stock or a manual plan where the investor buys more shares with earned dividends.
Reinvesting dividends allows an investor to increase the number of shares she owns without investing any additional outside money. A major benefit of stock dividend reinvestment plans is the ability to accumulate shares without paying in additional capital. As long as the stock in a dividend reinvestment plan continues to pay dividends, the number of shares in the account will continue to increase.
Reinvested dividends increase an investor's cost basis for tax purposes when the shares are sold. The dividends are taxed as they are earned, so shares purchased with reinvested dividends are after-tax. For example, an investor buys $1,000 worth of stock in a dividend reinvestment plan and has earned $100 worth of dividends, which have been reinvested. If the shares were sold, the investor's cost basis would be $1,100, reducing the investor's taxable capital gain or increasing a capital loss compared to the original investment amount.
Compound Dividend Increases
Reinvesting dividends will result in an increasing amount of dividends earned. Reinvested dividends buy more shares, and dividends are paid on a per-share basis. As long as the dividend rate stays constant or increases over time, the size of the dividend payment will increase with each distribution. The bigger dividend payments then purchase larger amounts of stock, causing the dividend payment to grow even faster. Reinvesting dividends allows an investor to use compound growth to increase both the number of shares and dividends earned.
No Guarantee of Investment Value
The factors discussed above increase the probability an investor's investment value will grow using a dividend reinvestment plan. However, dividend reinvestment does not guarantee positive investment returns. An investor can participate in a dividend reinvestment plan for years and accumulate a large number of shares, yet if the share price declines by a significant amount, the investor can still end up with a losing investment.
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