Reinvesting dividends in a taxable account

Introduction
One of the most frequently asked questions on our forum is whether to reinvest dividends in a taxable account. This page discusses the pros and cons of taking dividends in cash in the taxable account. Pros and cons of reinvesting dividends are cons and pros of taking dividends in cash, respectively. As such, they are omitted for brevity. Below, the term "dividends" is used for brevity, but it should be understood as "dividend and capital gain distributions" to be precise.

Pros of taking dividends in cash
It is a good idea to take dividends in cash in several cases:


 * If you are planning to use Specific Identification of Shares, taking dividends in cash avoids creating a lot of small tax lots. You can invest dividends along with new money.
 * If you are planning to do Tax Loss Harvesting, automatic reinvestments of dividends may accidentally trigger a wash sale.
 * If you are investing a relatively small amount of new money compared to the dividends you receive, taking dividends in cash may better facilitate rebalancing because you can choose not to put any new money (including dividends) into an outperforming fund.
 * If you have difficulty maxing out tax-advantaged accounts from your paycheck, and taking dividends from your taxable account would allow you to max out your tax-advantaged accounts, you may want to take dividends in cash and use the cash to max out your tax-advantaged accounts. (This situation may apply to investors who have inherited a large taxable account, or have built a large taxable account, ignoring the benefits of tax-advantaged accounts for many years.)
 * If your taxable account has a fund that is less than ideal but remains a suitable holding, you might want to take dividends in cash from that fund. For example, if you have Vanguard 500 Index Fund with a large amount of unrealized capital gains, and your current asset allocation calls for Vanguard Total Stock Market Index Fund for domestic stocks, you may want to take dividends from Vanguard 500 Index Fund in cash to prevent it from growing faster than Vanguard Total Stock Market Index Fund.

Cons of taking dividends in cash
Although taking dividends and capital gain in cash generally simplifies cost basis accounting, there are several caveats.


 * If you have Vanguard automatically reinvest distributions back into a fund with a purchase fee (Vanguard Emerging Markets Stock Index Fund for example), shares purchased with the distributions are not subject to the purchase fee. However, the saving there is extremely small.  If you assume 2% distributions from a fund with a 0.25% purchase fee, the purchase fee is 0.005% of the fund balance.
 * If you have Vanguard automatically reinvest distributions back into a tax-managed fund, the shares purchased with distributions are not subject to a redemption fee even if you redeem them within the first 5 years of the purchase.
 * There is a small opportunity cost for not investing dividends immediately.

Observations

 * The decision to take dividends in cash does not require you to use Specific Identification of Shares or do Tax Loss Harvesting.
 * If you are planning to use average cost basis, and you might want to sell some of the fund soon (to rebalance, for example), you will pay extra taxes to sell the shares you just bought. If you are planning to use average cost basis and know that you will continue to add to the fund, it doesn't matter whether you reinvest distributions.
 * If you are not planning to do Tax Loss Harvesting, and your average holding period is fairly short, use of average cost basis may not be very disadvantageous compared to Specific Identification of Shares because there is no big disparity in cost basis among shares you hold. Although your mileage may vary, the difference between the two cost basis methods may be small in the following cases:
 * You are in a very low tax bracket.
 * All or the vast majority of your taxable assets come from the last few years before retirement (perhaps as a form of catch-up).
 * You sell all or the vast majority of your taxable holdings late in the accumulation phase and buy other funds (possibly because you switch to low-cost index funds from expensive and/or tax-inefficient actively managed funds).