There are two primary ways to make money from a stock: an increase in the stock price and dividend payouts. The first one is straightforward -- you buy shares at one price and hopefully sell them for more in the future. Dividends aren't as straightforward, and their contribution to an investors' total return can be underestimated. But as of 2021, dividends accounted for around 32% of the S&P 500's total returns since 1926.
Companies generally pay dividends from their profits, so younger companies tend not to pay dividends as they reinvest their earnings to drive growth. More established companies, however, will offer a regular payout to make up for less growth potential and entice investors.
If you're invested in a dividend-paying stock or fund, you can either receive your dividend in cash or enroll in your broker's dividend reinvestment program (DRIP) if it offers one. A DRIP takes any dividends paid out and automatically reinvests them in the stock or fund that paid them. And if you have the option, you should strongly consider going the DRIP route.
Add to the effects of compound interest
Compound interest happens when the money you make on your investments begins to make money on itself. Thanks to compound interest, if a stock returns 10% annually, a one-time investment would increase more than 10 times in value over 25 years. Compound interest is one of the greatest phenomena in investing, and you can add to its magic by reinvesting dividends instead of taking them as cash.
Let's imagine you invested $1,000 monthly into a fund with a fixed 2.5% dividend yield that returned, on average, 10% annually over 25 years. Here's how the account totals would differ if you took the cash dividends versus reinvesting them:
|Reinvest Dividends?||Account Total After 25 Years|
Reinvesting the dividends allows you to benefit on two fronts. First, you increase the number of shares you own over time, and recall that each share (or fraction of one) will continue to enjoy a 10% return with each passing year based on the scenario above. But beyond that, since dividend payouts are based on how many shares you own, you also increase your total dividends payments over time.
Keep your eyes on retirement
The real difference between taking dividends as cash and reinvesting them happens in retirement. If you're able to accumulate a sizable amount of dividend-paying stocks, they can be a great source of retirement income. It may not be enough to single-handedly bankroll your retirement, but it can be a substantial addition to your other sources of retirement income like a pension and Social Security. If you're able to accumulate $1 million in dividend-paying stocks with a 2% average yield, that would be an additional $20,000 you can collect in passive income.
One of the best ways to save for retirement while getting the benefits of dividends is by using a Roth IRA if you're eligible. Roth IRAs allow you to invest after-tax money and then enjoy tax-free withdrawals in retirement. Usually, dividends received as cash are taxed at your capital gains rate, but if it's in a Roth IRA, you don't have to worry about that. Using a DRIP to add to compound interest and then receiving tax-free payouts in retirement is a win-win for investors.