When selecting a mutual fund, an investor is faced with a number of big choices. Among the more confusing decisionsis the choice between a fund with a growth option and a fund with a dividend reinvestment option. Each type of fund has its advantages and disadvantages, and deciding which is a better fit will depend on your individual needs and circ*mstances as an investor.
Key Takeaways
- Mutual fund investors who don't want to take their dividend payouts can choose from either a growth option or a dividend reinvestment option.
- With a growth option, the investor lets the fund company invest the dividend payments in more securities and ultimately grow their money.
- With dividend reinvestments, fund managers are allowed to use dividend payments to buy more shares in the fund on behalf of the investor.
- Individual retirement account (IRA) holders can't take dividend payments ahead of retirement without penalties and, instead, must opt to reinvest.
Mutual Funds With a Growth Option
The growth option on a mutual fund means that an investor in the fund will not receive any dividends that may be paid out by the stocks in the mutual fund. Some shares pay regular dividends, but by selecting a growth option, the mutual fund holder is allowing the fund company to reinvest the money it would otherwise payout to the investor in the form of a dividend. This money increases the net asset value (NAV) of the mutual fund.
The growth option is not a good one for the investor who wishes to receive regular cash payouts from their investments. However, it's a way to maximize the fund's NAV and, upon the sale of the mutual funds, realize a higher capital gain on the same number of shares they originally purchased. This is because all dividends that would have been paid out have been used by the fund company to invest in more stocks and grow clients' money. In this case, the investor does not receive more shares, but their shares of the fund increase in value.
Mutual Funds With a Dividend Reinvestment Option
The dividend reinvestment option is quite different. Dividends that would otherwise be paid out to investors in the fund are used to purchase more shares in the fund. Again, cash is not paid out to the investor when dividends are paid on the stocks in the fund. Instead, cash is automatically used by the fund's administrators to buy more fund units on behalf of the investors and transfer them to individual investors' accounts.
This method increases the number of shares owned over time and typically results in the account growing in value at a faster rate than if dividends were not reinvested. Many investment companies offer this service to shareholders at no cost.
Investors realize a capital gain upon the sale of their units in the fund, which in the case of the dividend reinvestment option will probably be more fund units than they started with.
Whether you choose a mutual fund with a dividend reinvestment option or a growth option, you are opting to forfeit regular dividend payouts in favor of allowing the fund to use that money to grow your holdings.
Selecting a Dividend Distribution Option
In most cases, it is up to shareholders whether they prefer to have dividends reinvested or paid out.An exception to this would be in the case of individual retirement accounts (IRAs). Dividends inIRAaccounts must be reinvested by shareholders who have not yet reached retirement age so they do not incur early withdrawal penalties from the Internal Revenue Service (IRS).
Dividend Payouts
In a dividendpayoutscenario, dividend distributions made by the mutual fund are paid out directly to the shareholder. If the shareholder chooses this option, dividends are usually swept directly into a cash account, transferred electronically into a bank account, or sent out by check. As is the case with the dividend reinvestment option, shareholders in most cases incur no fees for having their dividends paid in cash.
Choosing to reinvest dividends or have them paid out does not affect the tax implications of those dividends. From a tax perspective, dividend distributions are treated identically in either situation.
A shareholder can choose to skip both the growth and dividend reinvestment options and instead have the dividends paid out directly; in this scenario, the money is paid out directly to the investor.
The Bottom Line
No single mutual fund is perfect for every investor; that's why there are so many out there with so many different options. When investing in a mutual fund, it's best to examine its specific attributesto avoid investing in a fund that doesn't suit your unique requirements for growth or cash payout.
FAQs
Thus, the ones who want capital gain prefer the growth option. Note that it helps you reinvest your profits to maximise your returns. On the other hand, investors who prioritise income streams would prefer the Dividend Reinvestment Option. Notably, this one lets dividends compound with the help of additional units.
Should I go for dividend or growth? ›
Putting your money into dividend stocks means prioritizing stable returns over those with more upside potential. Stocks with high growth potential tend to invest all their earnings back into the business. Those companies have the biggest chance of rising in value.
Which option is better growth or dividend? ›
The NAV of growth option will always be higher than the dividend option because the profits re-invested in the growth option may grow in value over time. The total returns of growth option are usually higher than dividend option over sufficiently long investment horizon due to compounding effect.
Is it better to take dividends or reinvest? ›
Many financial experts recommend that you reinvest dividends most of the time – and I'm inclined to agree. The process is typically automated, doesn't incur any fees and gives your holdings a little (or a lot) of extra oomph.
Is it smarter to reinvest dividends? ›
Cashing out instead will preclude you from multiplying your investment. It May Take Longer To Achieve Long-Term Financial Goals: Dividend reinvestment leads to compounded growth. This makes it easier (and faster) to achieve your long-term financial goals versus keeping cash in a savings account.
Why dividend stocks are better than growth? ›
Dividend stocks are an important contributor to your long-term gains, and dividend-paying stocks tend to expose you to less risk than non-dividend-payers. That's why the majority of your stocks should be dividend-payers at all times.
At what age should you switch to dividend stocks? ›
As you pass through your 40s, you can gradually increase your holdings of high-dividend stocks and cut back on the riskier, more volatile growth investments. By the time you hit 50, around half your growth stocks should have been replaced by more stable dividend-payers.
How much dividend growth is good? ›
An average dividend growth rate is 8% to 10%. However, this can vary greatly among different stocks and industries.
Is Vanguard dividend Growth a good fund? ›
Overall Rating
Morningstar has awarded this fund 3 stars based on its risk-adjusted performance compared to the 1293 funds within its Morningstar Category.
What is the fastest way to grow dividend income? ›
Setting Up Your Portfolio
- Diversify your holdings of good stocks. ...
- Diversify your weighting to include five to seven industries. ...
- Choose financial stability over growth. ...
- Find companies with modest payout ratios. ...
- Find companies with a long history of raising their dividends. ...
- Reinvest the dividends.
What is the downside to reinvesting dividends? Dividend reinvestment has some drawbacks. One downside is that investors have no control over the price at which they buy shares. If the stock gains significant value, they'd still buy shares at what could be a high price.
When should you not reinvest dividends? ›
There are times when it makes better sense to take the cash instead of reinvesting dividends. These include when you are at or close to retirement and you need the money; when the stock or fund isn't performing well; when you want to diversify your portfolio; and when reinvesting unbalances your portfolio.
How do I avoid paying taxes on reinvested dividends? ›
Reinvested dividends may be treated in different ways, however. Qualified dividends get taxed as capital gains, while non-qualified dividends get taxed as ordinary income. You can avoid paying taxes on reinvested dividends in the year you earn them by holding dividend stocks in a tax-deferred retirement plan.
Are reinvested dividends taxed twice? ›
Dividends are taxable regardless of whether you take them in cash or reinvest them in the mutual fund that pays them out. You incur the tax liability in the year in which the dividends are reinvested.
Are dividends taxed differently if reinvested? ›
While reinvesting dividends can help grow your portfolio, you generally still owe taxes on reinvested dividends each year. Reinvested dividends may be treated in different ways, however. Qualified dividends get taxed as capital gains, while non-qualified dividends get taxed as ordinary income.
When should you stop reinvesting? ›
When you are 5-10 years from retirement, stop automatic dividend reinvestment. This is when you transition from an accumulation asset allocation to a de-risked asset allocation. In Summary: When in accumulation, reinvest dividends. When in transition or drawdown, don't!
Can you live off of dividends? ›
Living off dividends is a financial strategy that appeals to those aiming for a reliable income stream without tapping into their investment principal. This approach has intrigued many investors, from early-career individuals to those nearing retirement.
Is a high dividend growth rate good? ›
A high dividend yield can be appealing since you're getting more income per dollar invested, but a high yield isn't always a positive thing. It could mean that the company's stock price has been falling or dividend payments have been increasing at a higher rate than the company's earnings.
Do growth stocks tend to pay high dividends? ›
Because they operate in this relatively aggressive business cycle, high-growth companies tend not to pay dividends. Rather than return cash to shareholders this way, they tend to reinvest it.
