Growth vs. Dividend Reinvestment: Which Is Better?

Fact checked by Vikki VelasquezReviewed by Chip Stapleton

If you’re picking a mutual fund, you have some big choices. Among the most important is whether you want a fund geared toward growth or toward producing dividends you can reinvest. For both strategies, having income now is not the goal. First, you’ll want to know which is likely to leave you with more in your account over the long haul—the increase in the value from a growth fund holds or the dividends reinvested over time?

A 2023 Investment Company Institute report suggests American investors are divided on the question, with a near split between the amounts reinvested from capital gains (typically from growth stocks) and dividends (more usual for income-producing stocks and bonds)—$380 billion and $330 billion the year before, respectively.

Each has advantages, and choosing the best fit depends on your goals, risk tolerance, and tax situation. Below, we will help you determine which is most worthwhile for you.

Key Takeaways

• Mutual fund investors who take their dividends and reinvest them are giving up income now for (hopefully) more income later on, partly because they rely on the power of compounding.
• With a growth fund, your fund company invests in growth stocks that are more likely to increase in value over time.
• With dividend reinvestment, you’re buying more shares in the fund to increase your stake over time.
• Individual retirement account holders typically want to avoid the tax penalty of taking dividends early, so they opt to reinvest their dividends.
• However, there are several other tax implications you’ll need to review when deciding between these types of funds.

Growth Mutual Funds

Growth mutual funds are popular with those looking for capital appreciation (an increase in the value of the fund’s holdings). These funds focus on stocks of companies expected to grow faster than the overall market.

Let’s look at their main characteristics. Growth mutual funds often have higher expense ratios because of the expertise and analysts needed to find companies that are undervalued, have a track record of revenue growth, or have innovative products in the pipeline that portend future growth. To give you a sense of the fees to expect, on one extreme are the 10% of growth mutual funds in 2023 that had expense ratios of 0.61 % or less. Meanwhile, 10% have expense ratios of 1.7 %. The other four-fifths of growth funds are between these two poles.

Fund managers conduct extensive research to identify these companies and invest in their stocks. However, since these firms aren’t typically paying dividends yet, you would get returns mostly through capital appreciation.

Higher Risk, Higher Potential Returns

Compared with value or income funds, growth funds tend to have more risk and are more likely to have fluctuations in their stock price. However, with higher risk comes the potential for higher returns. When these companies do well, their stock prices can soar, leading to significant gains for the fund and, by extension, you.

Long-Term Investment Horizon

Growth funds are normally better for investors with a longer investment horizon. The companies held in these funds may experience short-term volatility, but the goal is to hold onto them for an extended period, allowing their growth potential to be realized. You should be prepared to weather market ups and downs and resist the temptation to sell during (hopefully temporary) downturns.

Diversification

Investing in growth mutual funds typically gives you diversification unless you choose one focused on a specific sector or theme. This diversification helps mitigate the impact of any single company’s underperformance on the fund.

Choosing Among Growth Mutual Funds

When selecting a growth mutual fund, you’ll want to ensure it’s a good investment for you and the amount of risk you can take on. First, review the fund’s past performance, though past success doesn’t guarantee future results. Look for consistent growth over longer periods, not short-term gains, which are more likely to be reversed.

Next, check the fund’s management team. Experienced managers who have steered funds through diverse market conditions are good to have on your side. Consider the fund’s fees and expenses; lower fees can make a substantial difference in net returns over time, but they can’t make up for low growth. You’ll need to see if this is worth any additional cost in the expense ratio. Also, assess the fund’s investment strategy to ensure it matches your investment horizon and risk profile. For example, funds focusing on high-growth sectors like technology might have more risk but offer a greater potential for returns.

Don’t overlook the size of the fund. Larger funds might have more resources for research and risk management, but smaller funds could offer the potential for higher growth rates. However, growth mutual funds are not a good fit if you want regular cash payouts. (Neither is dividend reinvestment, for that matter.) The companies these funds reinvest their profits back into the business, forgoing dividends in the meantime.

Reinvesting Dividends in a Mutual Fund

Reinvesting your dividends works differently from investing in growth funds. Dividends that would otherwise be paid out—which is less common in growth funds—are used to buy more shares in the fund. Dividend-producing funds primarily hold bonds, dividend-paying stocks, and other income-generating securities. Let’s look at some of the benefits and strategies behind dividend reinvestment in mutual funds.

Compounding’s Effects

By reinvesting dividends, you are likely to achieve higher total returns compared with simply collecting the income. When you reinvest, you are essentially buying more shares of the fund at varying prices over time, especially if you’re putting money into the mutual fund regularly through your paycheck. This strategy, known as dollar-cost averaging, can help smooth out the impact of market fluctuations. As the fund’s share price appreciates, the value of your reinvested dividends will also grow, contributing to your overall returns.

Reinvesting dividends is also a great way to benefit from the mathematics of compounding. When you reinvest your dividends, you use the income generated by the fund to buy more shares. Over time, these additional shares will also generate dividends, which can then be reinvested for even more shares, creating a snowball effect. This compounding is the path to significant growth over the long term.

Automatic Reinvestment Plans

Many dividend-producing mutual funds offer automatic dividend reinvestment plans (DRIPs). With a DRIP, the dividends you receive are automatically used to buy additional shares without you needing to do anything. This ensures that your dividends are consistently reinvested, allowing you to take full advantage of compounding.

Important

Whether you choose a mutual fund with a dividend reinvestment option or a growth fund, you are forfeiting regular dividend payouts for greater returns later on.

Dividend Payments

For dividends you choose to receive, the mutual fund distributes payments directly to you in your checking or brokerage account. Reinvesting your dividends or paying them out does not affect their tax implications. For your taxes, dividend distributions are the same in either event.

Selecting a Dividend-Producing Mutual Fund

To be able to reinvest your distributions, you’ll, of course, need to be with a mutual fund producing dividends. First, assess the fund’s investment strategy and portfolio composition. Look for funds that align with your investment goals and risk tolerance. Some funds focus on high-yield bonds, while others hold dividend-paying stocks. Consider the fund’s exposure to different sectors, geographies, and asset classes so they’re at the right level of risk for you.

Another crucial thing to examine is the fund’s expense ratio. Compare the expense ratios of different funds in the same category to find the most cost-effective option. It’s harder to give statistics for the typical expense ratios of these mutual funds. They range quite a bit from one to the next. For example, among Investopedia‘s best eight funds for regular dividend income, the average expense ratio is 0.53%. Meanwhile, the range for the expense ratios is almost a full percentage point, from 0.08% on the low end to 1.06% on the other.

You’ll want to consider these fees against the fund’s historical performance: returns, volatility, and the consistency of its dividends. While past performance does not guarantee future results, it can give you some confidence about what to expect as an investor.

So Which Is Better? Investing in Growth Funds or Reinvesting Dividends?

Reinvesting dividends has the advantage of compounding distributions over time, which can lead to exponential growth in your investment portfolio. The same can be said about growth funds, where capital appreciation can also lead to exponential growth.

But which will most likely fit your needs while providing the best returns over time? There’s no universal answer. Both dividend reinvestment and growth funds have advantages, and the choice depends on your individual goals and circumstances. That said, we won’t leave you in the lurch. Leaving a lot that is specific to different funds aside and considering all else being equal (similar fees, returns, management experience, etc.), some pointers should help you decide, given where you are in your investing life. Here are the questions you’ll need to answer for yourself:

1. What is your risk tolerance? If you’re more risk-averse, reinvesting dividends might be preferable since this strategy tends to be more stable and offers (some) predictability. If you are willing to trade having more risk for the possibility of higher returns, investing in growth funds will be more appealing. You’ll need the stomach for stressful times when markets fall while waiting for faster growth to eventually reappear. For example, let’s say your mutual fund holdings looked pretty similar to the S&P 500. In 2022, your portfolio would have dropped about 20%. But the following year, you’d be feeling pretty giddy anytime you logged into your mutual fund account, as the S&P 500 shot up a startling 24% that year. The decline was a momentary blip if you’re not due to retire for some time. But not so if you needed those funds in 2022.
2. What is your view of the market for now and the medium term? During volatile or down markets, the ability to reinvest dividends at lower prices will generally outpace any capital appreciation in a growth fund. Many companies that catch the eye of your mutual fund advisors should have consistent dividends. In addition, the bonds in an income-producing fund tend to do better as stocks slide. However, suppose you think the economy (or the specific areas and assets covered by your chosen fund) will likely be quite substantial. In that case, growth funds will generally outperform income funds because of rapid capital appreciation and tax advantages, which we’ll discuss in a moment.
3. What are your goals? Consider what you hope to achieve financially. Reinvesting dividends is effective for building up funds steadily and securely. How long until you plan to retire? If it’s sooner than later, you could be devastated by a massive drop in your growth fund when you need it. Growth funds tend to have an advantage if your timetable is longer than dividend-focused mutual funds. This means they are more likely, but not always or even nearly so, to outpace what your dividend reinvestments would. Not only would you gain from capital appreciation but also from the tax advantages of growth-oriented funds that dividend-paying funds usually don’t have.

Growth Funds

• The fund invests in stocks likely to increase in value over the long term

• Your shares in the fund rise without increasing the number you hold

• Taxes are deferred until you sell your shares or units

Reinvesting Your Dividends

• Dividends are used to buy more units in the fund

• Each reinvestment increases the number of units or shares you own

• Reinvesting means your cost basis has gone up, potentially lowering your taxes

Tax Implications of Dividend Reinvestment vs. Growth Funds

When dividends are reinvested, they’re still subject to taxes when paid, whether taken as cash or reinvested to buy additional shares. Taxed in the year received, qualified dividends (those paid by American or certain foreign companies that meet specific criteria) have lower capital gains rates (0%, 15%, or 20%, depending on your income), while non-qualified dividends are taxed as ordinary income.

There can be tax benefits for reinvesting your dividends because you increase your investment’s cost basis over time. Every time you reinvest dividends to buy more shares, the total amount you’ve spent increases. When you eventually sell your shares, your cost basis will be higher because of this. So, you should pay less in taxes on any profits when you sell your shares, say, to get cash to pay expenses. Thus, the more you’ve invested (including reinvested dividends), the less profit you make on paper when you sell, which can lead to fewer taxes.

Meanwhile, growth funds are more likely to produce capital gains realized when you sell shares in the fund for a profit. If shares are held for over a year, profits are taxed at long-term capital gains rates. If held for less than a year, gains are taxed as ordinary income. The ability to defer taxes with growth funds can be a major advantage for tax planning. It gives you the ability to time the sale of your investments for when your income is lower, thus qualifying for a lower capital gains tax rate. For those who need regular income, the tax on reinvested dividends might be worthwhile for the benefits of compounding.

Both have advantages: if you’re being taxed on your dividends, you’re at least sure of receiving income, which might not happen if a growth fund runs into problems. This is generally considered the more conservative investment approach. But the extra risk you’re taking with a growth fund could mean more capital appreciation and certain tax benefits now and later. Whichever way you lean, this is clearly a case when it’s wise to consult a tax professional or financial advisor to fully understand how these strategies align with your tax situation and investment goals.

Is It Better To Take Dividends or Reinvest?

In most cases, it’s advisable to reinvest dividends and keep your money invested. However, people who rely on an income from their investments, such as retired people, may prefer to take the dividends. Other reasons you might take the cash include using the proceeds to top up other areas of your portfolio, keeping the asset allocation balanced and your portfolio diversified. In this case, you’re reinvesting the dividends—just elsewhere.

Are There Investments Where I Can Get Growth and Dividends?

A balanced or hybrid fund is a prime example of what you have in mind. It invests in a mix of stocks and bonds, aiming for capital appreciation while also earning income from dividends and interest. Another example is dividend growth stocks, which are from companies with a history of increasing their dividend payouts over time.

However, the most used option is a target-date fund. Easily a favorite among mutual fund investors by assets these funds have held in recent years, your fund’s holdings are based on when you want to retire. It changes its strategy from initially seeking growth and allowing for more risk to becoming more conservative and locking in gains as you near retirement. This gives you both the advantages of a growth orientation, especially early on, and the income and stability you’ll need when you retire.

How Are Reinvested Dividends Taxed?

In the U.S., reinvested dividends are taxed the same as those cashed out. In the eyes of the Internal Revenue Service, you are still getting paid. When you reinvest your dividends, either automatically or manually, you must report them as income on your tax returns.

The Bottom Line

No mutual fund is perfect for every investor. That’s why so many are out there, each catering to different needs and risk tolerances. When investing in a mutual fund, it’s best to examine its specific attributes to avoid investing in a fund that doesn’t suit your needs for growth or income. A major part of your review should be the tax implications. Dividend-focused and growth strategies have very different effects on your taxed income, and it’s going to be a large part of how you choose among these options.

Read the original article on Investopedia.