Dividends make up a substantial fraction of the returns on many investments, and most of us reinvest them — at least in our early years.
The easiest way to reinvest your dividends is to automate the process. Simply direct that money straight back into whatever produced it.
And yet… My wife and I don’t do this. We could. And perhaps, for the sake of simplicity, we should. But we don’t. At least not entirely. Why not?
As with many things, this decision traces back to the structure of our portfolio, with fairly significant holdings on the taxable side. In our retirement account, we do automatically reinvest dividends. But on the taxable side, we reinvest manually.
There are three main reasons for this.
Probably the biggest reason is that manual reinvestment helps us minimize the need to rebalance our portfolio. Over time, your investment portfolio is bound to drift away from your target allocation. Eventually, you need to rebalance.
In a retirement account, you just sell some of one thing and buy more of another. It’s very easy and there are no tax consequences. But on the taxable side, you’ll end up realizing gains when you do this.
To protect against having to rebalance, we simply let our dividends accrue and then we periodically (typically quarterly) direct them into whichever asset class is low to bring it back into line — or at least move it in that direction.
Minimizing tax lots
Another benefit of manual reinvestment is that it minimizes tax lots. Whenever you buy shares in a taxable account, you create a new tax lot, the cost of which has to be tracked for (future) tax purposes.
Instead of creating a new tax lot with every single dividend payment from every single fund that you own, you can once again let your dividends accrue and then periodically create a single (larger) tax lot.
This is less of an issue now that there are strict requirements for cost basis reporting, but I still like the simplicity that results from generating fewer tax lots than would be produced by automatic reinvestment.
Protecting against wash sales
Last but not least, manual reinvesting can help you avoid wash sales if you ever engage in tax loss harvesting. This is a relatively complex topic that deserves a post of its own, so I won’t delve into it too deeply here.
(Keep an eye out for more on this in the future.)
For now, I’ll just say that you can’t buy more shares of whatever you’re harvesting during the 30 days before or after you sell to record the loss. If you do, the IRS will treat it as if you never sold those shares in the first place.
By switching off automatic reinvestment, you maintain complete control over what gets bought with those dividends, thereby helping you avoid wash sales.
Why not manually reinvest?
Of course, manual reinvestment puts the burden on you to make sure that your dividends actually get reinvested. Perhaps you don’t trust yourself or you just don’t want to deal with it. If that’s the case, great. Go with automatic reinvestment.
But if you want to maintain control and make your portfolio a bit more tax efficient, manual reinvestment is an excellent option.