When it pays to reinvest dividends

This is also the case with other indices, as illustrated below.

Value of £10,000 invested on 30 December 1999

Source: Hargreaves Lansdown, all performance data as at 30/12/99 to 16/12/14

Reinvesting dividends is an easy way to get more shares of the funds or company stock you already own. By reinvesting dividends over the long term you can enhance both capital growth and income potential. This means that even if you are a growth investor you can invest in equity income and meet your aims.

"You get your dividend money working for you by being invested in the market," says Michelle McGrade, chief investment officer at TD Direct Investing. "If you don't need the income this is much more effective as your money gets a pitiful rate held as cash or you might fritter it away if it is at your disposal."

You also achieve a smoothing effect: by making a regular reinvestment four times a year or however often the equity pays out, you are price averaging, which could work to your advantage if you invest when the price of the share is low. "If a share is out of favour when you invest you get paid dividends while you wait for it to turn and put them in while the company is at a lower price," adds Adrian Lowcock, head of investing at AXA Wealth.

Dividends can also grow over time further adding to your investment and helping outpace inflation.

It is also convenient: once you have set up a reinvestment function you do not have to do it manually yourself every time.

Disadvantages of dividend reinvestment

If you need income, reinvesting your dividends is not a suitable strategy. "You need to consider your lifestyle and investment objective - do you have sufficient income to live on, and what would you do with it if you didn't reinvest it?" says Ms McGrade.

If you reinvest the dividend when the price of the company is high you will not get as many shares. This strategy is more effective following sell-offs - it would have been better just after the financial crisis than now, for example.

You may not get the full benefit of the reinvestment set out in theoretical examples because brokers and platforms often charge to reinvest dividends. And while the charges may not seem much it is not efficient to reinvest with a small sum. If, for example, the payout is only £10 to £20 and you have to pay £1.50 to reinvest, it is significant amount of the total.

"It would be better to collect the dividends, build them up and invest them as a sizeable lump sum," says Mr Lowcock. "As a rough guide, if it costs you 5 per cent of your dividend or more it is not worth reinvesting it."

Before you decide to reinvest see what your broker charges to do this. Not all brokers allow you to do this, and some don't allow you to do it for every company. You may also to have to fill out some forms and go through an administration process to enable reinvesting, although with some this can be done quickly online.

Platform and brokers policy on dividend reinvestment

Source: Investors Chronicle and Boring Money

Mr Lowcock says you should also think about where the value of the company is going, and whether you want to build up your holding in it. Although you can set up an automatic dividend reinvestment feed with some brokers and platforms you need to periodically review what you are reinvesting into as the companies' outlooks may have changed, meaning it is not a good idea to keep investing in them.

It is also a good idea to regularly review your reinvestments as companies may stop paying dividends, cut dividends or cease to exist, so you may wish to replace them. To compensate for potential shortfalls with one holding Ms McGrade suggests you have a well-diversified equity income portfolio.

With shares you need to consider the spread - the difference between the buying and selling price - and whether this is favourable to you.

Reinvesting the dividend doesn't mitigate any tax you are liable for on the dividend. With the changes in dividend tax rules coming in next April, to avoid their effects it is a good idea to hold dividend paying assets in an individual savings account (Isa) or self invested personal pension (Sipp), once they go over the new tax-free dividend allowance of £5,000.

The new dividend tax regime means investors with share portfolios worth around £140,000 or more could be worse off, but there are a number of other things you can do to mitigate this.

With a unit trust or open-ended investment company (Oeic) rather than pay to reinvest dividends it is simpler to buy the accumulation unit where this is done automatically for you.

"Any income from accumulation units will be taxable even though the income is rolled up," says Mr Lowcock. "You get a tax voucher at the end of the tax year and will be liable for additional tax."

An alternative for investment trust investors could be investment company savings schemes as some of these do not charge to reinvest dividends, although they are not necessarily the most cost-effective way to hold investment trusts and may offer a limited range of trusts. You should check the charging structures as these this vary from scheme to scheme.

Effective dividend tax rates (%)

Under current dividend taxation investors benefit from a 10 per cent tax credit. This means that, for example, when calculating tax on £10,000 of dividends for a higher-rate tax payer it is done as follows:

• £10,000 in received dividends.

• 10 per cent tax credit means that it is assumed the tax is already paid - ie, £1,111. So the actual gross dividend is £11,111.

• £11,111 at 32.5% is £3,611

• However, you have already paid £1,111 so only need to pay £2,500 in tax on the £10,000 received - ie, 25 per cent.

"So, under the current system, basic-rate taxpayers pay no tax on their dividend income, while higher-rate taxpayers pay an effective rate of 25 per cent and additional-rate taxpayers pay 30.56 per cent," explains Mr Lowock.