Reinvest dividends and capital gains or not?

[Marcos8]

ok I'm really new at this. Just set up my first IRA ( traditional IRA). I owed some taxes and decided that doing something that had a tax deductible contribution would be better than sending Uncle Sam everything. I chose a Vanguard VTIVX target retirement fund based on my age. This all seemed simple enough and like a good place to start. In setting up the account I had to choose between reinvesting dividends and capital gains or putting them in a money market settlement fund. I chose the later as I briefly read that it may make things easier for me at some point etc but I'm still not sure exactly what it will do? Can anyone explain in a simple manner what this process is about and why it would be easier for me to do one or the other? I have found many web topics but they escalate quickly into terminology that I do not understand. Thanks!

[Marcos8]

Will dividend reinvestment help grow my IRA quicker? I understand at some point that I will have to pay taxes on this money... Is tracking these dividends and their reinvestment really that difficult?

[bada_bing]

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@Marcos8 wrote:

Will dividend reinvestment help grow my IRA quicker? I understand at some point that I will have to pay taxes on this money... Is tracking these dividends and their reinvestment really that difficult?

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Dividends from a mutual fund are just part of the investment return. The money comes internally from

3 sources, short term gains from investments the fund bought and then sold at a profit, long term

gains the fund bought and then sold after a longer term for a profit and dividends & interest paid by

investments held by the fund. If you owned shares of VTIVX in a taxable account, the differences between

the different dividends types would have tax differences. Because you hold your VTIVX shares in a tax

deferred retirement account, there is no difference in how they are treated. They become just part of the

pool of tax deferred money you will someday pay taxes on when you withdraw it.

If you choose to reinvest your dividends, the dividend money will automatically be used to buy more

shares of the fund that paid them. If you choose to not reinvest them, then the dividends will be paid

and go into whatever holding that your account defaults to, usually some type of money market fund.

From there, it is up to you to choose where to invest the money. 

Overall, automatic reinvestment isn't a big deal, one way or another. If you have a tendency to ignore

your retirement account, automatic reinvestment might be a good thing in that it gets your dividend

money working for you right away in the investment you have already choosen. If you are a little more

hands on, and might choose to put the new money into something different, or already have several

mutual fund holdings that might need to be rebalanced, the dividend money is available for that purpose

if you don't automatically reinvest. Your choice, won't make a great deal of difference either way.

There are some other non-typical uses for dividends from within a retirement account that shouldn't

be an issue for you just starting out. It is possible to pay dividends out of a retirement account before

retirement and not pay an early withdrawal penalty, just the taxes due. For the vast majority of people,

the reason they have their money in a retirement account is to let the growth compounding happen

without taxes dragging down the returns. Taking dividends out and paying taxes sort of defeats the

whole reason to use a retirement account in the big majority of cases.

[Marcos8]

Thanks for the reply. Another potentially silly question...but if I don't reinvest dividends and just keep the same amount of shares... How does the fund make money? What dictates whether the share price goes up or down? Thanks

[bada_bing]

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@Marcos8 wrote:

Thanks for the reply. Another potentially silly question...but if I don't reinvest dividends and just keep the same amount of shares... How does the fund make money? What dictates whether the share price goes up or down? Thanks

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You are invested in a "target date" fund for 2045. (Good first choice BTW if you are somewhere around 30).

A target date fund is invested in a mix of stocks and bonds. The percentage invested in stocks and bonds

is heavily towards more stocks now, because there is ~30 years until the target date of 2045. As it gets closer

to 2045, the fund will gradually sell some stocks and buy bonds. They do this to become more conservative

of the principle (the owners invested money). Stocks are higher potential return, but are riskier and more

volatile in price than bonds. 

The share price (called the NAV or net asset value) of your mutual fund is the value of the small piece of the

invested pool of money the share represents. You can track the NAV daily to see how the fund is doing

if you wish. Just be aware there is a lot of noise in daily share prices and it takes weeks or months to see

the overall trend. As I said, your mutual fund is invested in stocks and bonds, more stocks than bonds right

now. Stocks pay dividends and bonds pay interest (also called coupons), and that is where some of the return

of owning a mutual fund is. This money is given to the mutual fund shareholders as part of the fund's dividend.

The other part of the profit a mutual fund holder hopes to make is appreciation. That is when the market value

of the stocks and bonds owned by the fund go up in price. That is what causes the NAV price to go up or down

on every trading day, the changes in the market price of all the stocks and bonds owned by the fund.

If you choose to not reinvest the dividends, you will maintain the same number of mutual fund shares you have.

If you do reinvest your dividends, the number of shares you own will slowly grow as the dividend payments are

used to buy more shares. The quoted past performance of mutual funds assumes reinvesting the dividends. It 

isn't necessarily a bad (or good) decision to reinvest. If you want to limit your exposure to a fund and would

rather invest new money in something else then it could make sense to not reinvest. The only drawback to not

reinvesting is that it requires you to take action to get the dividend money invested. If you do nothing, the dividend

money will sit in whatever cash holdings are placed in for your account, probably a money market fund. money

market funds currently make almost nothing for interest. But they are stable and safe.  

[tacpoly]

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@Marcos8 wrote:

Will dividend reinvestment help grow my IRA quicker? I understand at some point that I will have to pay taxes on this money... Is tracking these dividends and their reinvestment really that difficult?

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I recommend reinvesting dividends -- the past returns you see posted by the funds assume reinvestment, by the way. 

Tracking dividends and reinvestment shouldn't be that difficult.  Your fund (monthly or quarterly) statements usually specify how much dividend you earned and how many shares were purchased with them.  However, when it comes to IRAs it doesn't really matter in the end because all you have to do is track how much you contributed (minus how much you took out if you had to take money out before retirement) over the years.  Anything over that number will be taxable when you start taking money out during retirement.  So it's actually easier to track if you reinvest because all your gains (in value and dividend) are in one place. 

I guess this is one more reason to put money into a Roth IRA -- you don't have to worry about taxes because it is completely tax-free when you take it out (including gains) at retirement age.  So if you are under the Roth IRA contribution income limit, I highly highly highly recommend doing that. 

[Marcos8]

I wanted to open a Roth but since part of what finally pushed me over the edge to open an account was that I had a tax liability that I wanted to reduce and any contributions to a Roth would not be tax deductible. I plan to open a Roth too... And basically at the end of the year if I owe taxes contribute to the traditional and if I don't contribute to the Roth. 

Another question... If I reinvest dividends do these reinvestment count towards my max 5500/ year contributions? I would guess so... Thanks everyone for the responses so far. So much to learn

[bada_bing]

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@Marcos8 wrote:

Another question... If I reinvest dividends do these reinvestment count towards my max 5500/ year contributions? I would guess so... Thanks everyone for the responses so far. So much to learn

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No, dividends - whether you reinvest them or not - stay in your IRA unless you withdraw them (bad idea).

If you don't use automatic reinvestment or invest them yourself, the dividends will just sit in a money fund

inside your IRA earning almost nothing. It is okay to let them sit for a short while if you need a little time

to decide where to put them, but don't just ignore them. Or, you could just let the investment take care

of itself with automatic reinvestment.

Dividends don't count towards your annual contribution limit. Eventually, after your account has grown, the

annual dividends you earn will be larger than what you are allowed to contribute for the year. But you can

always make an IRA contribution up to the annual limit (assuming you had taxable income during the year).

There are income limits for Roth IRAs and the deductability of traditional IRAs, but anyone, even Bill Gates,

is allowed to make an IRA contribution up to either the annual limit or their taxable income for the year.