Growth vs. Dividend Reinvestment: Which is Better?

When selecting a mutual fund, an investor is faced with a number of great options. Among the most confusing decisions is the choice between a fund with a growth option and a fund with a dividend reinvestment option. Each type of fund has its advantages and disadvantages, and deciding which one is the best fit will depend on your individual needs and circumstances as an investor.

Key takeaways

  • Mutual fund investors who do not want to receive their dividend payments can choose between a growth option or a dividend reinvestment option.
  • With a growth option, the investor allows the fund company to invest the dividend payments in more securities and ultimately grow their money.
  • With dividend reinvestments, fund managers can use dividend payments to purchase more shares in the fund on behalf of the investor.
  • Holders of individual retirement accounts (IRAs) cannot accept dividend payments before retirement without penalties and must instead choose to reinvest.

Mutual funds with growth option

The growth option in a mutual fund means that an investor in the fund will not receive dividends that can be paid by the shares of the mutual fund. Some stocks pay regular dividends, but by selecting a growth option, the mutual fund holder allows the fund company to reinvest money that it would otherwise pay the investor in the form of a dividend. This money increases the net asset value (NAV) of the mutual fund.

The growth option is not good for the investor who wants to receive regular cash payments on his investments. However, it is a way of maximizing the NAV of the fund and, after the mutual funds are sold, obtaining a greater capital gain on the same number of shares that they originally bought. This is because the fund company has used all the dividends that would have been paid to invest in more stocks and increase clients’ money. In this case, the investor does not receive any more shares, but his shares in the fund increase in value.

Mutual funds with dividend reinvestment option

The dividend reinvestment option is quite different. Dividends that would otherwise be paid to investors in the fund are used to purchase more shares in the fund. Again, no cash is paid to the investor when dividends are paid on the fund’s shares. Instead, the fund managers automatically use the cash to purchase additional units of the fund on behalf of investors and transfer them to individual investors’ accounts.

This method increases the number of shares owned over time and generally causes the value of the account to grow at a faster rate than if dividends were not reinvested. Many investment firms offer this service to shareholders at no cost.

Investors make a capital gain on the sale of their fund shares, which in the case of the dividend reinvestment option will likely be more fund shares than they originally had.

Whether you choose a mutual fund with a dividend reinvestment option or a growth option, you are choosing to forego regular dividend payments in favor of allowing the fund to use that money to grow its holdings.

Selecting a dividend distribution option

In most cases, it is up to the shareholders whether they prefer dividends to be reinvested or paid. An exception to this would be in the case of individual retirement accounts (IRAs). Dividends in IRA accounts must be reinvested by shareholders who have not yet reached retirement age so that they do not incur penalties for early withdrawal from the Internal Revenue Service (IRS).

Dividend payments

In a dividend payment scenario, dividend distributions made by the mutual fund are paid directly to the shareholder. If the shareholder chooses this option, dividends are usually transferred directly to a cash account, electronically transferred to a bank account, or sent by check. As is the case with the dividend reinvestment option, shareholders in most cases do not incur commissions for the payment of their dividends in cash.

Choosing to reinvest dividends or have them paid does not affect the tax implications of those dividends. From a tax perspective, dividend distributions are treated identically in any situation.

A shareholder can choose to skip the dividend reinvestment and growth options and instead have dividends paid directly; In this scenario, the money is paid directly to the investor.

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The bottom line

No mutual fund is perfect for all investors; that is why there are so many with so many different options. When investing in a mutual fund, it’s best to examine your specific attributes to avoid investing in a fund that doesn’t suit your unique growth or cash payment requirements.

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Mark Holland

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