Dividends, the portion of earnings that a company or mutual fund distributes to shareholders, may seem like a relatively small component of your overall portfolio. But they can play an important role in your financial success over time.

You’ve probably heard that it’s a good idea to reinvest your dividends, and it’s true that reinvestment can help your portfolio grow more quickly. But for some investors, such retirees, regular dividend distributions can provide a useful source of income. The course of action that makes the most sense for you will depend on your individual needs.

Types of Investments

Dividends are commonly associated with stocks. But professionally managed assets such as mutual funds, exchange-traded funds, real estate investment trusts and separately managed accounts can collect earnings from their underlying investments and distribute them to shareholders.

You likely receive stock dividends quarterly (though some stocks follow different schedules), while your funds may distribute them to you annually, semiannually, quarterly or monthly. You can check the frequency in your fund’s prospectus.

Reinvesting vs. Withdrawing Cash

With dividends you have two basic options:

Reinvest for long-term growth. If you’re primarily concerned with growing your portfolio over many years, reinvesting dividends generally is an appropriate strategy. Because of the power of compounding, reinvested dividends have the potential to boost your return over time, assuming your investments gain in value. Automatically reinvesting has an added benefit of forcing you to stay disciplined about saving.

Another benefit is that dividends are often reinvested free of transaction costs. Check with your account’s administrator to see if any charges apply.

Withdraw as cash. If you’re primarily concerned with paying monthly expenses or reducing high-interest debt, taking dividends in cash may be the right decision.  Drawing income directly from investments can provide you with a supplemental source of cash flow if you’re retired or other income sources are insufficient to meet expenses. Also, using dividends for income keeps your principal invested, potentially preserving retirement savings for longer.

Understand the Risks

Reinvesting dividends can have some drawbacks. By adding to your holdings in the same stock or fund, you may be increasing your exposure to that investment — and therefore your risk — if it later experiences a loss. A growing position in a particular investment can also throw your portfolio’s asset allocation off balance, which may mean incurring costs when selling shares to rebalance.

To avoid some of these pitfalls, consider setting up accounts to deploy dividend distributions directly into a separate investment or, if you want to keep your funds available for future investment opportunities, a money market fund. Make sure you include any transaction costs in the decision.  

Don’t Forget About Taxes

Reinvesting dividends can also present challenges during tax time. For taxable accounts, each purchase you make with dividends must be added to your cost basis, meaning the original value of the investment when you bought it. (Inherited and gifted assets have different tax basis criteria.)

When you sell the investment, the higher cost basis is used to calculate your capital gain or loss. A careful accounting of changes in cost basis — including increases from your reinvested dividends — prevents you from over- or underpaying income taxes. None of this is relevant to your assets held in retirement accounts, because dividend reinvestments are taxed the same as regular contributions when you begin taking distributions.

Evaluate Your Strategy

Bear in mind that dividends aren’t guaranteed, and you should be comfortable with the risks of investing in dividend-producing assets. If you originally opted to reinvest dividends, consider talking with your financial advisor to assess whether this is still an appropriate choice.