Reinvest: Interest, Dividends, & Capital Gains

Should You Reinvest Cash from Your Mutual Fund?

By: Robert F. Abbott, freelance writer and author

Many mutual funds routinely distribute cash to their unitholders (the ‘shares’ of a mutual fund are known as ‘units’). Should you reinvest that money?

Distributions from stock funds involve dividends, which originate at dividend-paying companies. Others involve capital gains, the profits made by the fund when it sold shares of companies for more than it paid. And, bond mutual funds distribute interest earned from the bonds they hold.

In this article, I’ll take you through the main issues connected with distributions (I use the word distributions to cover interest, dividends and capital gains)? Let’s review the possibilities.

You Need the Cash Now

If you have already retired, or if you depend on the earnings from your investments, then the answer will be straightforward: You will take the cash rather than reinvest.

Diversify Your Funds

You might also choose to take the cash if you want to diversify your portfolio. For example, you might start investing by buying units of a bond mutual fund. With the proceeds paid out by the bond fund you could then start buying units of an equity mutual fund. If your proceeds from the first fund are relatively small, you might let them accumulate for several months at a time before buying into the second fund.

Mutual Fund or Brokerage Fees

Sometimes you will find costs attached if you reinvest, such as taxes and/or from brokerage fees. Although many fund providers offer reinvestment at no charge, check to ensure yours does. In it does, again let the distributions accumulate and buy new units a few times a year, rather than every month.

Compounding

Still building your nest egg? In that case, reinvesting will normally give you the best results. Here are a few reasons why:

At the top of the list comes compounding, which some have called the Eighth Wonder of the World. Reinvesting distributions will speed up the compounding that sees your money making money.

Suppose you have a fund that gains an average of 4% a year, before distributions. The Rule of 72 indicates your investment will double in 18 years (72 divided by 4 = 18).

Let’s suppose, as well, that your mutual fund pays distributions that amount to another 4%, for a total of 8% a year. If you reinvest your distributions at this rate, then your fund will double in just 9 years (72 divided by 8 = 9).

Now let’s take this one step further: Let’s assume you’re 30 years old and you expect to retire at age 65. This means your mutual fund has 35 years to grow before you begin using all the distributions to support you in your retirement.

If your mutual fund has been doubling every 18 years, it will double almost twice (35 divided by 18 = 1.9). So if you had a $10,000 investment at age 30, and added or taken nothing from it, you would have $19,000 at age 65.

But, if your fund doubles every 9 years, you’ll have significantly more. Your fund will have doubled almost four times (35 / 9 = 3.9), and at age 65 your $10,000 investment will have grown to $39,000.

No Temptations

If you’re like me, you can think of a million ways to spend any extra money that comes along. If you formally elect to reinvest your distributions, they will automatically go back into the pot, and you will be earning money on your money, instead of spending it. That will be a small amount at first, but if you can reinvest those distributions continually, you’ll see big gains after a few years.

What’s the Process to Reinvest?

In many cases, the fund company or brokerage selling the funds will ask you how you want to handle the distributions. Or, in a do-it-yourself situation, you might need to click or check somewhere on the application form.

Not sure about the fund’s policy on reinvestments? In that case, take a look at its prospectus, the document that spells out all the critical details about its operations.

As we’ve noted, watch out for fund companies or brokerages that want to charge you a fee for reinvestment. Although not necessarily a deal-breaker, I would be tempted to look elsewhere if I was charged each time I reinvested a few dollars in distributions.

Finally, before you make a decision, ask yourself about tax consequences. The rules vary from country to country, and according to individual circumstances.

All in all, these last few cautions should remind us that owning units in a mutual fund is somewhat like owning a small business: It’s important to keep costs down as much as possible. Americans can start their search for more information with this article, Mutual Fund Fees and Expenses, at the U.S. Securities and Exchange Commission’s website.

Reinvest: Conclusion

If you can afford to do so, reinvest your distributions, whether they come from interest, capital gains, dividends, or anything else.

Reinvestment triggers compounding, which means you earn on your earnings, speeding the rate at which your nest egg grows.

Before making any decision, though, review the pros and cons, and if the latter, watch for fees or tax implications that may drain away the gains from compounding.

Make the Eighth Wonder of the World work for you if you can, by reinvesting in the mutual funds you own.