How reinvesting dividends grows your income: a 20-year example

Invest $25,000 in dividend stocks, add $250 a month, and reinvest every dividend. After 20 years, the portfolio pays about $11,900 a year in dividends. Take the same dividends as cash instead of reinvesting them, and year-20 income is about $7,100. Reinvesting adds about two-thirds more.

The example

We used LifeCalculator's dividend income calculator with these assumptions:

• $25,000 invested today, plus $250 a month
• A share price of $60 with a 3.5% dividend yield
• Dividends that grow 6% a year, and share prices that grow 4% a year
• 15% tax on dividends, the most common U.S. rate on qualified dividends

Over 20 years, you put in $85,000 in total.

With and without reinvestment

The cash-taking investor received $69,318 of dividends over the 20 years to spend along the way. The reinvesting investor received more in total, but put it back into shares, and ends with a portfolio worth about $110,000 more and much higher income.

Three engines of growth

Dividend income grows in three ways at once, and reinvesting turns on the third:

1. New money. Each monthly contribution buys more shares, and each share pays dividends.
2. Dividend raises. Established companies often raise their payouts every year. At 6% a year, the dividend per share roughly triples over 20 years without you buying anything.
3. Reinvestment. Each dividend buys more shares, which pay their own dividends next year. This is compounding applied to income.

These multiply each other. More shares receive higher dividends, which buy more shares.

Yield on cost

Yield on cost compares this year's dividends with the total you invested. Here, year-20 dividends of $11,925 on $85,000 invested is a 14% yield on cost, even though the stocks still yield 3.5% at today's prices. It's a useful way to see what patient investing does to income. Remember it's a backward-looking measure: if you sold and reinvested elsewhere, you'd get the market yield, not your yield on cost.

Time and taxes

Extending the same plan to 30 years pushes annual dividends to about $36,500 and the portfolio to about $656,000, on $115,000 invested. The last ten years add more income than the first twenty, because compounding speeds up as the base grows.

Taxes slow reinvestment down because every dividend is taxed before it's reinvested. Holding the same stocks in a tax-sheltered account such as an IRA or 401(k) raises year-20 income from $11,925 to about $13,100 in our example.

What this model simplifies

• Dividends get cut. Companies reduce or suspend dividends in recessions. A diversified fund spreads that risk, but the growth rate won't be smooth.
• High yield isn't always better. A very high yield often means the market expects a cut. Moderate yields with steady growth have a better record.
• Prices move. The model assumes steady 4% price growth. Real prices swing widely from year to year.

Try your own mix in the dividend income calculator. Change the yield and growth rate, switch DRIP on and off, and download the year-by-year table to Excel.