The stock market is roaring, and Q3 dividend season is upon us. There are many benefits to investing. But mostly you invest to make money. And you invest through your 401(k) to accumulate, and then preserve, money that you will ultimately use in retirement. Remember, the money you put into your account is expected to stay there until you are age fifty-nine and a half, and if you take money out of it before that age, you may be hit with a 10 percent tax penalty (and you would need to pay any applicable ordinary income taxes). But a big advantage of the 401(k) is the tax advantaged growth you get over the long term.
When you invest through your 401(k), there are essentially two ways that your account will appreciate.
- First, you make money through capital gains. This means that the contributions you make to your plan will rise in value as the stock market rises. On average, the stock market returns 8 percent over the long-term. Yes, recently the stock market has been on a winning streak like no other in the last 4 years, but don’t get too euphoric. You can reasonably expect an 8 percent return on your investment.
- Second, you can make money through dividends. Dividends are company earnings that are paid back to you, the shareholder, in the form of income. Not all companies offer dividends, but if they do, it’s a solid way to earn more money. Dividends can be paid on a quarterly, bi-annual or annual schedule – it all depends on the company and the mutual funds you are invested in.
So what can you do with your 401(k) dividends? You have two options depending on if you are invested in mutual funds and/or company stock (if offered), which are two commonly offered assets in 401(k) plans. Let’s take a look.
- Mutual Funds. Any dividends received through your mutual funds will automatically reinvest. You have no choice here. When dividends are paid through your mutual fund, the money goes right back into the fund and you buy up more shares. You may think, “wait a minute, so I don’t even get that money?” True, you won’t get the money today, but when it’s reinvested, you will get more back in the far future. You will benefit from a process called dividend reinvestment, and by doing so you are accelerating your earnings growth and increasing your 401(k) portfolio value.
- Company Stock. If you happen to invest in company stock that is offered in your 401(k), you will have two options on how you can elect to treat those dividends. You can elect to have them paid out to you in cash, in which they will be treated like taxable income. Or, like the mutual funds, you can have them automatically reinvested, in which they won’t be treated like taxable income. In this way, you can also accelerate your earnings growth and portfolio potential.
The best advice I can give is to reinvest your dividends. It may seem gratifying today to take those that you may get from company stock, but honestly, it’s not going to be that much and you’ll have to pay capital gains tax on it. And remember, if you are invested in mutual funds, your dividends will be automatically reinvested back into the funds. So with the stock market booming, and Q3 dividend season upon us, make sure you know where your dividends are going.
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