Dividend Reinvestment Plan: Is it better to opt or not?

We already know that dividends are essential because they provide a steady cash flow for monthly necessities like paying bills, groceries, buying medicines, etc. or you would love to spend that extra cash for your vacations and of course for other perks. However, if you reinvest those dividends, in an amount of time they can grow into enormous sums of money. 

Let's know all about dividend reinvestment here, and find out whether it is the correct choice for you. 

What you need to know about Dividend Reinvestment

People usually consider stocks and mutual fund dividends as similar, but in reality, there are quite different from each other. In mutual funds, the amount of dividend paid to you is out of your profits. Therefore, the amount of dividends paid to you decreases the NAV by the same amount as your mutual fund. Wherein, dividends from stocks are your additional income, and due to dividend distribution, the stock price does not come down. Stock prices are based on the general sentiments of the stock market.

Dividend Reinvestment Plan, in simple terms - The dividends are declared but not paid, In fact from that dividend amount additional units are bought for the same mutual fund.

If you do not need a steady stream of cash from dividends, it's a good idea to reinvest them. In the long term, the biggest advantage is the compounding of returns. With every dividend, you are increasing the number of shares you hold which, in turn, increases the total return potential of the investment. 

The slight downside is that you have no control over when your money from the dividends is used to buy new stock, which means you might be buying new shares at a less-than-optimal time.

Other alternatives to the Dividend Reinvestment Plan

When you invest in mutual funds, you normally have the choice of 3 plans under each fund viz. Growth Plans, Dividend Payout Plans, and Dividend Reinvestment Plans. So, what exactly is the difference between the three of them? 

Let us understand the growth and reinvestment option in mutual funds as well as a comparison of the dividend reinvestment plan vs the growth plan. Also, what is the difference between growth and dividend reinvestment and dividend plans? But first, the concepts.

*Disclaimer- The way of choosing a mutual fund scheme depends solely on your investment objective. 

Growth Plan: In a growth plan of a mutual fund, there is no payout. All profits made on the portfolio are ploughed back into the scheme, and therefore the value of a growth plan compounds over the longer term.

Dividend Payout Plan: Under this plan, the investor receives regular payments from funding houses. An individual can receive the amount monthly, quarterly, half-yearly, or yearly depending upon his needs.

Dividend Reinvestment Plan: The amount of the dividend which was to be distributed to the investor is used by the company to buy more units, thereby increasing the overall unit-holding. This, in the long run, generates a higher capital gain than the Dividend Payout Option because of the increased number of units. 

Let us understand DRIP with an example

# Dividend of Rs. 10,000 (5000*2) will entitle him to 833.3333 units Rs. 10,000/ NAV of Rs. 12.

Benefits of Dividend Reinvestment Plan

Continue compounding - The small dividends can add up to huge investment gains if invested regularly. Every amount which is added to the mutual fund will add to the total number of shares owned. Hence, when share prices rise, one gets the benefit from an increase in the value of more shares, likewise more dividends because of the additional shares, and when additional dividends are reinvested, you get even more shares. 

Overspending habits - When you invest, you do not spend. If you took the dividend in cash, you might be tempted to spend it before you get around to investing it. When you develop the habit of reinvesting dividends, the focus is solely on your future needs instead of your present desires. By allocating cash dividends to your future, you commit to a better financial condition down the road and avoid impulse buying now.

Reasons to not Reinvest Dividends

Cash requirement - It is surely a smart decision to opt for cash for your dividends. Circumstances could occur at any time, such to get fired the next day, maybe the stock market could crash, or you might have been hospitalized. If you don't have sufficient cash available, you might have to sell stock at unattractive prices. Also, cash is very important to take advantage of the next dips in the stock market or a particular stock.

Valuation purposes - You can lose a considerable sum of money if you buy stocks at all-time high valuations. If the valuation of the stock is unattractive, the best way is to invest in more undervalued opportunities instead of reinvesting in an overvalued stock.

Cost of living - Reaching passive income retirement, is the ultimate goal of dividend reinvestment. Once your portfolio becomes sufficient, you can simply live off the periodic dividend payments. As you reach that level of financial dependence, you should obviously be taking the dividend payments as cash for your necessary expenses vs reinvesting them back into the stock.

Taxation

In the previous budget, DDT was in the hands of the dividend payer, which is the mutual fund company. In Budget 2020-21, It is now taxable at the hands of the investors at the applicable.

*Impact of Surcharge and Tax Not Considered. DDT is not applicable from FY2021 

Dividend Income

--Added to Income from OTHER SOURCES

TDS: 10%                                 Covid TDS: 7.5%

(if dividend > 5K)                (till march 2021)

Conclusion - So should you Reinvest your dividends?

Ultimately, it all depends on your financial situation, your need for funds as well as your personal short-term and long-term goals. If you make a comfortable income and don't feel the need for any upgrade, reinvesting your dividends to fund your retirement could make the most sense. But, if you expect some sort of regular income/ dividends from your mutual fund investment or that extra income to enjoy more experiences while you are young, you could be better off using the dividend payments throughout your lifetime. 

Now that you know which option is the best for you, it's time you make your own call!