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In 2023, the interest in investing is growing. Thanks to websites that make investment and trade a lot simpler, more people than ever have a grasp on the industry. Still, quite a few of these newcomers need to fully catch up on the different terms and practices of the industry. For example, a lot has yet to learn what compounding means. Many are unaware of the pros and cons of reinvesting your capital gains and dividends. A few may not even know the difference between the two. So, in this article, we would like to explain these terms and give you a few pointers for the future.
Capital Gains vs. Dividends
Before we get into the nitty-gritty, we need to know the difference between dividends and capital gains. Once you are fully aware of what these words mean, the differences will be self-explanatory. So, capital gains are the profits you make when you sell a stock for more money than you bought it for. To take a random example, let us say you’ve purchased a stock for $5. A couple of months later, that same stock is worth $15. So you sell it for $15, and you’ve made a $10 profit. Those $10 are your capital gains.
Dividends, on the other hand, are cash payments made from your shares within a company. Annually, every company pays dividends to its shareholders. The dividends depend on the company’s performance and how much money circulates within. Frequently, shareholders get dividends based on percentage. So, for example, if a company that trades in $200 annually pays $20, shareholders get a 10% dividend.
What is Compound Interest
Once you get your capital gains or dividends, you can choose to reinvest. The initial interest you’ve earned becomes a vehicle to reinvest and make an even greater profit. And we call that more significant profit a compound interest. It all works on the principle laid out by Benjamin Franklin back when the United States was founded:
“Money makes money. And the money that makes money makes more money.”
In essence, the goal of compound interests is to accelerate the growth of investments. However, you should be aware that in doing so, you are also accelerating the development of your debt balances. Therefore, you owe more money the longer you maintain a compound interest. In this article, we will try to figure out if doing so is worth the effort and explore whether it is wise to reinvest capital gains and dividends. So, without further ado, let’s get into the crux of the issue.
Reinvesting Capital Gains
The main question most traders as themselves is: “Should I reinvest my capital gains?” While it may seem deceptively simple, there is actually a lot of thought that goes into this dilemma. After all, there are quite a few factors to consider before you reinvest your capital gain. A few of these factors include the following:
· Market volatility
· Taxation implication
For anyone who still may not be aware, let’s look at some of the pros and cons of reinvesting your capital gains. Once you are more informed, you will likely be able to make a better decision.
The Pros of Reinvesting Capital Gains
The main benefit of reinvesting your capital gains is that you can make more money than what you originally started with. Remember Benjamin Franklin’s quote from before. For example, if you’ve started with $5 and sold your stocks for $15, you now have an extra $10 to invest. From there, you just need to make a series of successful investments before accumulating wealth. The tricky part is making the right choice when investing.
Another considerable benefit of reinvesting your capital gains is delaying the CGT, or capital gains tax. For those who don’t know, the Internal Revenue Service taxes capital gains depending on whether they are short- or long-term. The taxes on short-term gains run from 12% to 35%, depending on your income. Long-term capital gains taxes run a bit differently. However, if you reinvest your capital gains, you technically have not made a profit. And therefore, you delay your tax payments. You should know there is no way to avoid paying this tax. Eventually, you will have to pull your capital gains and pay the CGT. However, you can develop a better strategy and payment plan by delaying it.
The Cons of Reinvesting Capital Gains
There are two significant downsides to reinvesting your capital gains. The first and most obvious one is that you get no money. You’ve reinvested your capital gains and therefore have no money to spend, should you need to. In other words, while you may profit in the future, you break even in the present. It is worth noting that this wouldn’t be a significant problem for anyone who is well off. However, for investors who need to spend money at the moment, the problem is apparent.
The second significant risk you might have already picked up on. Namely, no investment is risk-free. So, every time you reinvest your capital gain, you risk failure. If you’ve made a short-term gain, and you feel like that is enough for you, then collect your money and be on your way. However, reinvesting is probably the better choice if you want a more significant profit. Just be aware that the greater profit comes with greater risks.
Reinvesting dividends is another popular way to profit in the trading world. Many newcomers might be taken aback by the process. However, once you’ve found out how reinvesting dividends is done, you will see it is pretty simple and easy. The real question shouldn’t be “how to reinvest,” but “should I reinvest?” So, let’s take a look at when reinvesting dividends is the right choice and when you should just take the cash and be on your way.
When to Reinvest?
Think about why you want to reinvest. The goal is to accumulate more shares and build up wealth over time. If that is the case, then the answer is obvious. It would be best to reinvest your dividends when you are confident you can get a better deal. If you are just starting out and have built up a pretty good intuition, reinvest your dividends. You might lose out in the short term, but you will certainly benefit in the long run. Just remember, there is a certain risk with reinvesting, and you need to take that into account.
When to Get the Cash
The obvious answer is: when you need the income. Have you got bills to pay? Take the cash. Are you near retirement? Take the cash. Are you running low on funds? Take the cash. However, there are also other times when you should take the money. For example, when the stock or fund you’re investing in is underperforming. Do be careful with this one, though. The dividend percentage is now always a reflection of the company’s success.
Hopefully, you now have a broader context when deciding whether to reinvest capital gains and dividends. You are aware that by reinvesting, you can delay the CGT and come up with a better payment plan. Not only that, but you will likely accumulate more wealth over time. However, no investment comes risk-free. So, when all is said and done, we can’t tell you how to handle your funds. But, hopefully, what we’ve done is help you make better, more-informed decisions regarding your capital gain and dividend earnings.
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