Tuesday, March 10, 2015

Turbocharge Income Growth with Dividend Reinvestment

Many of you are aware of the power of compounding. When you invest in a company that manages to grow dividends every year, and you are able to reinvest those dividends as well, you are turbocharging the growth of your dividend income. If you put in that potent combination in a tax-advantaged account such as a Roth IRA, and you have essentially planted a seed that will generate tax-free income for many years to come.

I usually reinvest dividends automatically only in my tax-deferred accounts such as IRA’s. I always reinvest dividends automatically in tax-deferred accounts, because I am limited in the amount and timing of contributions, and I cannot easily move money from one account to another. I recently reviewed two separate investments I made in Roth IRA on two separate occasions in the past.

The first investment I did in a Roth IRA was in 2009, when I purchased shares of Abbott Laboratories (ABT). After 6 years of reinvesting dividends, I ended up with shares of ABBV and ABT, which are generating approximately 8.90% on the amount I put to work initially. I was able to achieve this merely by checking the button to “reinvest dividends”. I liked the company Abbott between 2008 and 2012 ( prior to its split). I am still holding on to both shares, and I still reinvest those dividends in the Roth IRA.

The second stock investment I did in a Roth IRA was in 2011, when I purchased shares of Phillip Morris International (PM). I also chose to reinvest dividends automatically. After three years, the company managed to increase quarterly dividends from 77 cents/share to $1/share. My yield was 4.70% at time of purchase, and it has subsequently increased. If I add in the power of reinvested dividends, my yield on cost increased to 6.90%.

In a few more years, those two single investments will be generating a double-digit yield on cost, that will be growing even if I start withdrawing those dividends. The lesson learned is that those dividend seeds need to be planted as soon as possible. After that, they need to be let unattended, in order to let them grow into mighty oaks in the future. Do not be discouraged if you are not starting out with a lot of money – afterall some of the best dividend investors turned small amounts into huge endowments for their favorite charities.

I do believe that dividend reinvestment is important, whether you reinvest dividends selectively or automatically. However, I usually do not automatically reinvest dividends. I basically accumulate the dividends from all the stocks I own, add in the cash deposits for a given month, and then decide to put that money to work in a few attractively priced dividend growth stocks. I do this selective dividend reinvestment, because I want to avoid situations where I mindlessly reinvest dividends into a company whose share price is ridiculously overpriced. This was the case with Coca-Cola (KO) and Wal-Mart (WMT) between the late 1990s and early 2000s. If you reinvest dividends in overpriced securities, no matter how great the companies are, you are shortchanging your income and capital growth for years.

I also reinvest dividends selectively, in order to diversify my portfolio, and make it easier to do my recordkeeping. If I started with 100 shares of Realty Income (O) in 2008, and I put the dividends to buy shares in a new company each year, I would be sitting on 100 shares of Realty Income today, as well as shares in 6 – 7 other enterprises. Thus, I would have not only successfully reinvested dividends, but also improved my portfolio from a diversification standpoint. The downside however is that even if I reinvested those original Realty Income dividends into companies that are better values than Realty Income, there is no guarantee that those other companies will do better than a truly passive reinvestment in the original shares that produced the income.

With automatic dividend reinvestment, it is easy to see that putting 100 shares of Realty Income in your Roth IRA in May 2008 for $25.80/share has resulted in 146.2 shares throwing off $331.60 per year. This is equivalent to an yield of 12.85% over the cost in 2008. With the method I employ in my taxable accounts, you cannot do that calculation so easily. However, it is easy to see when total dividend income keeps increasing above the organic rate of growth, even when no new deposits are added to the account.

Full Disclosure: ABT, ABBV, PM, WMT, KO, O,

Relevant Articles:

The importance of investing for retirement as early as possible
Yield on Cost Matters
How to Generate an 11% Yield on Cost in 6 Years
Roth IRA’s for Dividend Investors
Investors Should Look for Organic Dividend Growth

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