Reinvesting stock dividends and minimizing any withdrawals are healthy for a growing mutual fund. A few decades of growth will be very helpful to retirement (so start young to avoid missing out). Stock dividends are costly withdrawals, because it leaves less money to grow. Gains on reinvested dividends are compounded and gains earn more future gains, which then that gain keeps earning more future gains, etc., continually. Any withdrawal can seriously reduce future compounded gain earnings.
Bond dividends are interest income, but this article is about stock dividends. Bonds are different than stocks. Resell value of bonds are affected by interest rate changes, however bonds purchased directly and held until maturity or until recalled are then redeemed at full face value, without value change (like cash in a bank account, paying interest — except bonds that are sold prior to redemption do vary in price due to interest rate changes.) So yes, bond dividends are income, same as any interest. Bond dividends are just interest payments, taxed as regular income tax rates (but stock dividends are mostly taxed as capital gains after the first year).
But stock dividends paid do automatically equally reduce a stocks price value remaining (because the company's value decreases when they pay out dividends — more below). Withdrawing stock dividends are the same as any other withdrawal, simply lowering the overall value remaining. However, stock dividends can be reinvested to retain the same fund value, and then, the additional shares will increase compounding of future earnings, which is then significant income.
Near 80% of the S&P 500 companies pay dividends in some degree. See a list of these ranked by dividend (but the percentage number also depends on current price). The S&P 500 index funds distribute that S&P 500 dividend proportionately into your fund shares.
It is a mistake to think of stock dividends as new income to be withdrawn. The dividend money was moved from the companies (who's value then went down by millions or billions) into your fund, so the remaining stock price (which reflects the value of the company) was equally reduced when the dividend was paid. Due to the corresponding price drop, the value sum of withdrawn dividend and the remaining stock value remains exactly the same value, no gain. The value change due to that dividend transaction on that day is zero. Withdrawing dividends are only a simple direct withdrawal that reduces your current fund value (same as any other withdrawal).
Whether dividends are income depends on viewpoint. Any withdrawal from a fund might be considered as personal retirement income, but any withdrawal is of course just subtracted from remaining fund value (which is NOT new income). It may not be obvious, but the dollar value of any stock dividend PAID is also immediately subtracted from the current fund price and value (because the companies value is reduced by the pay out, reducing the stock price, so that your fund value remains exactly unchanged). The dividend is NOT a gain in the fund value, because the price drops equally to retain the same value (the rest of this page is those details). If dividend is withdrawn, it simply reduces the fund value (and also its future earnings), but you do have the withdrawn cash. However if the dividend is reinvested, the fund still will maintain the same value then (which as yet on that first day is still NOT income). Or if the dividend is reinvested, the additional fund shares can gain in the future. But withdrawals really do greatly limit the future compounded gains.
The share price drop of a small dividend may be hard to notice in the numbers, but a large dividend (perhaps only paid once a year in December) can drop your favorite stock price enough to take your breath away that day. :) But that price drop simply means that the dividend was paid. If you reinvest the dividend, your fund will still have the same value, and a few more shares (still exactly same value despite the lower price). There is no devious plan doing this, but yes, the price is automatically adjusted down, same as is done in events such as splits. Because the companies value does drop by the paid out dividend, which might be $Billions for the companies, so their remaining value did seriously drop. But you do now also have that dividend, and this is really just market action, since the stock no longer promises to pay the dividend already received by the owners, and new buyers will not bid higher to include it. True of every stock and fund that pays a dividend (and even bond funds paying interest). Any dividend lowers the price that day, so the dividend is Not income on that day. But dividend reinvestment does add a few shares (often four times each year) which certainly increases long term compounding of future gains.
You will learn this if you own a fund that pays perhaps a 8% dividend one time at year end, because you will see a sudden 8% drop in fund price and value on the day the dividend is paid (but you did receive the 8% dividend). Then it becomes either a withdrawal, or a reinvestment of dividends which buys additional shares (more shares at the lower price which is still the exact same fund value on that day). Either way, it is Not income on that day, but the additional reinvested shares certainly do have considerable future growth value potential.
You might figure that since you have to pay tax anyway on the dividend paid this year, you might as well withdraw it. That might make sense during retirement since you are probably withdrawing anyway, but it is NOT income that day. Since the fund value drops accordingly. It is simply a withdrawal of fund value then, so the fund drops that much too. But if reinvested, the fund value remains unchanged (details below), and in the long run, the compounding of the reinvested shares will be a real earnings payback in the future (and this purchase will also increase the cost basis, reducing future tax when it is sold).
Many probably don't understand market dividends correctly or completely, and it is a deeper subject than probably imagined. Dividends are taxed if as income, but stock dividends are NOT an actual immediate income increase on that first day. Any stock or fund gains due to dividends are in the future gains of having additional shares if reinvested, but there is no income on the dividend day, or if withdrawn. This is not intuitive, but true nevertheless, because on the day the dividend is paid, the stock or fund share price is reduced by the exact dividend value, reduced the same dollars per share amount. The lower share price exactly balances out the dividend amount. So it's a wash, and there is no income gain on dividend day. This is a known fact (maybe not well known, but known), and if a nonbeliever, I suggest seeing Google discussions about closing price adjustments. If you withdraw the dividend then, there is no added income at all, not ever, because the fund price was adjusted down equally. The price may grow in the future, but it goes down on that first day. Reinvesting dividends seriously does increase long term compounding gains of your fund's value, but withdrawing them is simple withdrawal, without any added income (and in fact, is considerable reduced future earnings, long term).
Withdrawing dividends is no small thing. Here's a chart from the S&P calculator page calculating the real cost of withdrawing dividends (due to lost compounding). It computes past S&P history of $25,000 invested for up to 50 years (this copy computed 3 Feb 2022). This is the past, the future is unknown, but the concept still seems a good bet.
|S&P 500||No withdrawals||Withdrawing all dividends|
Long term, reinvesting dividends is a major part of S&P earnings. In fact, it's a major part, if a long time duration.
The cost of WithDrawals is the money "that could have been" minus the money remaining available.
A 1% dividend paid by a $100 Billion company totals $1 Billion dollars (and there are Trillion dollar companies, Microsoft and Apple, who do pay dividends). It is assumed that the promise of a dividend to be paid has bid up the stock price accordingly, expecting to receive it. But the moment it is paid, then it is not still forthcoming, and since the companies value has also decreased with payment out, buyers will reduce their buy bids, and the stock price drops accordingly. The companies value is reduced by the dividend they pay out, which is a huge total value. But companies also pay out much money for many other things, which does not affect the stock price until stock buyers hear of it and decide they won't pay as much for the decreased company value. But this actual dividend price drop we see is Not because of any buyer's bid. The powers that be have already subtracted the dividend from the stock price before any sell, before the close price is actually reported.
We now pay income tax on the dividend in the current year, regardless if withdrawn or reinvested. That is just a detail of congressional law which requires it. And since tax on the dividend will be paid, buying stock with any tax paid reinvested dividends increases cost basis, compensating by lowering the final taxable value when sold. Since 2012, the brokerages are required to keep track of dividends reinvested (adds to cost basis), but unknown cost basis due to older past reinvested dividends could be a tax problem when selling older funds. But if there were no dividend tax (yet) to affect cost basis, the only cost basis we would ever need to know is the investment that we actually paid in. Tax on the dividends and the compounded final result would be paid when sold. No dividend complications a few times a year to remember. All we would need to know for taxes is shares and final price and corresponding investment cost actually paid.
I am no financial expert, but this seems simple. My notion is this dividend situation is caused by the US Congressional law requiring dividends to be taxed at time of payment (like interest, which if stock, it's not). The dividend could instead be paid into the stock account with zero cost basis, as untaxed value gain (unrealized gain, like any price gain), which it would and should be for us. If the dividend is withdrawn then, the withdrawal is immediately taxed with zero cost basis. If reinvested in the fund, it increases shares, but with zero cost basis. It could be left untaxed until sold and withdrawn (unrealized gains exactly like the all the rest of the account, since we don't know the future value until we sell it at that future time). The untaxed dividend would not increase cost basis then, it and its earning gains would just be more account gain. Buyers would surely account for the companies lower value by bidding less for the stock then (until future gains), but this would all be automatic and reasonable, and corrected by future gains. There would be no risk of unknown dividends for taxes — it's all in the final dollar value and the actual cost. It seems the correct action, and Congress still gets all the tax due, but just not as fast as they want to spend it.
A mutual fund itself is not bid for (other than ETF funds), a mutual fund only has a computed value once a day after market close, which is its only price until the next close. A fund cannot be bought or sold until the next close. This dividend price reduction effect is due to the value and price of the stocks of the companies owned by the fund. Buyers will not pay for a dividend no longer included or expected, so the expected price goes down by the same amount when the dividend is paid out (but performed by market buyers, not by some congressional law). But dividends do lower the value of the paying companies, which in turn affects the stock price (normally done by buyers, not congressmen).
Reinvesting the dividend does buy more shares which will earn additional growth in the future, which is a big plus... the reduced price will recover and growth will be greater with more reinvested shares, as it accumulates and compounds (which is income then). But if the dividend is instead withdrawn on that first day, then there is no additional gain, not on that day or any day. It was then just a withdrawal, different in that it leaves all of the same previous shares but at the lower price (whereas ordinary withdrawals reduce the shares but don't affect the price. However the effect on fund value is the same). So don't withdraw the dividends imagining it was income. Reinvest it for greater future growth, which in time will increase income.
Numeric Example: At the moment the dividend is paid, you still have only the same value as before.
If you had 100 shares at $100 per share (value $10000) and if the dividend is $1 per share (1%), then the dividend is $1 x 100 shares = $100. But then the fund price drops by that $1 per share, to $99.
If you withdraw the dividend money (or otherwise don't reinvest it), you have the $100 plus 100 shares at $99 of value $9900, which is the same $10000 total value again. You have ended it there, but there was no income, and no way to imagine it was or will be income. It was just a withdrawal then. The fund value likely will continue to increase in the future, but this withdrawn dividend has no part in it.
If you instead reinvest the dividend (strongly suggested), the reduced $99 price would buy $100/$99 = 1.0101 shares. You then have 101.0101 shares worth $99, which is 101.0101 x 99 = $10000, still the same value as before (still no income at that moment). However the reinvested 1% dividend provided 1% more shares then. So as yet on that day, there is no dollar income either way, however the 1% reinvestment does have 1.01 more shares to contribute to future growth prospects (at each such dividend, perhaps four times each year). When the fund grows, each percent of new dividend becomes larger too, every year. This does compound gains impressively, increasing future long term income. The shares purchased with the dividend dollars also increase the fund cost basis, so those dollars are not taxed again.
If you wait until the fund price gains back the dividend price, and then withdraw that dividend value, that gain is income, but it is still the same as withdrawing any other fund gain. It is simply just a withdrawal, which reduces fund value again.
To compare, if there were no dividend, and if you simply withdrew $100 (meaning sold that much) in this same example situation, withdrawals reduce shares instead of price. The $100 is one share, so you would have the $100 plus 99 shares at $100, which again, is the same value you previously had (again, some of just moved out of the fund). Or alternately, reinvestment of the dividend also remains the same value as before, $100 plus 1.0101 shares at $99 of value $10000 again today, because it is one more share than before. But that extra share (in this example) is an additional $1 for every dollar of future price gain (basically always the 1% gain more). But as to current value, some might consider any withdrawal as income, but if it comes from money you already had, you gained no value. But future growth from the reinvested dividend is valuable, see the High Cost of withdrawing dividends on previous S&P 500 page.
So if you imagine dividends are added income that you can withdraw without affecting your remaining fund value, you might rethink this. It is Not income then, because while dividends do add cash to your account, this then lowers your fund price to the same previous total value. So it was Not income, the result is simply a withdrawal of your own fund money. Reinvested dividends do provide more shares for future price gains, however that's still the same effect as if instead the price had just been left unadjusted.
Most brokerages also have a plan for you to reinvest dividends from individual stocks. Here is Vanguard's description. It will seriously increase your compounded long term growth. Basically, then stock dividends go into a mini-fund of just those dividend shares.
It may be hard for market beginners to believe that the dividend drops price to produce zero income gain on the day dividends are paid, reinvested or not. I'll try to help here, because it clearly does drop, which produces zero dividend income on that day. For clear factual evidence of the price drop, just look at the stock or fund stock price history (those few that show this), for example historical fund prices on Yahoo.
|S&P 500 Index VFIAX|
|Mar 23, 2022||411.20||411.20||411.20||411.20||411.20|
|Mar 23, 2022||1.372 Dividend|
|Mar 22, 2022||417.68||417.68||417.68||417.68||416.31|
|May 06, 2022||156.01||159.44||154.18||157.28||157.28|
|May 06, 2022||0.23 Dividend|
|May 05, 2022||163.85||164.08||154.95||156.77||156.54|
|May 18, 2022||263.00||263.60||252.77||254.08||254.08|
|May 18, 2022||0.62 Dividend|
|May 17, 2022||266.11||268.33||262.46||266.82||266.20|
On the day of the dividend ($1.372 Mar 23 2022), the VFIAX data column "Adjusted Close" price simply subtracts the exact dividend from the "Close Price (417.68 - 1.37 = 416.31). Same thing for Apple and Microsoft (which are in the S&P 500).
The fund price dropped because the prices of stocks in the fund dropped (those that pay a dividend). On that dividend day, this becomes the funds actual effective Close price. Other overnight market action can make a stock have yet a different price at the next day Open. However a mutual fund technically does not have an Open price, but can only be bought or sold at the new Close price that next day. In this example instance, the S&P 500 did also fall a bit more that next day (meaning the stocks that make up the fund dropped more overnight).
The Adjusted Close prices account for corporate actions like dividends, splits, spin offs, or issuing more shares. These are actions of the individual companies in the S&P 500 fund, and the fund simply reflects the total. Some of these adjustment reasons affect all prior prices in the history. Here is a link to the math of Adjusted Close. Also many other pages about Adjusted Close are found at Google. These clearly explain that dividends drop the share price equally. And it does happen. Again, this is a known fact, and if a nonbeliever, I suggest seeing Google discussions about closing price adjustments.