Should You Auto-Reinvest IRA Dividends?

Dividend reinvestment can be a real boon to investors, especially within an individual retirement account, where you're protected from certain tax consequences. Inside an IRA, you can reinvest your full payout, compounding your portfolio faster than if Uncle Sam takes a bite of each dividend. Reinvesting your dividends can be very simple, too.

But is it always smart to reinvest your dividends? Here are some questions you need to ask yourself to see whether you should automatically reinvest your IRA dividends.

» Read more: How to invest in dividend stocks

What is your time horizon?

Like any money you plan to invest, dividends that you reinvest need time to compound. Financial advisors recommend allowing any money put into the market at least three to five years to grow. If your time horizon is short and you need the cash, it may not be ideal to reinvest your dividends immediately.

Do you have more than three years before retirement? Reinvesting may be a great way to get that money compounding as soon as possible. The longer you have it working for you, the better off you’ll likely be. And if the market does dip in the short term, you won’t even remember it when retirement rolls around. Time will probably have turned that dividend into even more money (and dividends).

Are you taking IRA distributions, or plan to take them soon?

If you’re already taking distributions on your IRA, or you plan to in the next year or two, then it might not make sense to reinvest your cash. Over the short term the market can do almost anything (namely, plummet), and if you’re required to take IRA distributions, or simply need the money, it’s hard to reinvest your dividend and then watch a market downturn shrink it.

If your time horizon is short, consider holding the dividend in cash. Or if you need a bit of return on those dividends without the volatility of the stock market, you could think about dropping those dollars into a short-term bond fund. But remember, even bond funds can go down.

» Read more: Check out the best IRA account providers

Do you want to reinvest your dividends manually?

Part of the brilliance of reinvesting dividends automatically is that the brokerage will reinvest the full amount into the stock or fund at no cost, even buying fractional shares. You get to compound the full amount and save a commission, too. Saving that commission is especially valuable when you’re just starting out investing, so automatic reinvesting makes a lot of sense early on.

Those who are more experienced in the ways of the stock market may want to reinvest manually, though, especially if they’re buying individual stocks. Individual stocks are more volatile than the market as a whole, so sharp investors may be able to reinvest dividends when a stock is cheaper, leading to potentially even better returns than automatic reinvesting. But this method costs more time and money (trade commissions) compared with having it done automatically.

Manual reinvesting is not for everyone. If you’re not willing to commit time to the market, you’ll probably do much better with automatic reinvestment. Consider just putting it all on autopilot while you enjoy life.

Do you want a Roth or traditional IRA?

If you’re trying to compound your dividends and maximize your retirement savings, your choice of IRA can help. With a traditional IRA, you pay taxes on your gains when you take distributions, so the dividends pile up tax-free for a while, but the taxman eventually gets a cut.