Here's What Happens When You Cash Out Your Dividends

Investing in stocks is a great way to grow wealth over time. And you can make money with stocks in more ways than one.

First, if you load up your brokerage account with quality stocks and hold your shares for many years, there's a good chance they'll appreciate in value, setting you up to sell them at a profit. But you can also make money by investing in stocks that pay dividends.

How dividends work

When a company pays dividends, what it's doing is sharing some of its profit with shareholders rather than investing all of that money back into the business. Some people like the idea of dividend-paying stocks because they get to collect payments on a regular basis, usually every quarter.

To be clear, companies are not required to pay dividends. And it's possible for a company to pay one consistently for years and then stop that practice. Companies can also change their dividends by increasing or decreasing them.

What you can do with your dividends

When dividends land in your brokerage account, you have two options. You could reinvest them so they're able to help you grow wealth, or you can cash them out and use that money as you please.

You should know that there's no penalty for taking your dividend cash and running with it, so if that's the route you wish to take, go for it. In fact, some retirees have a strategy of holding dividend stocks and cashing out their dividends regularly to use as income to cover their living expenses. And cashing out your dividends won't make a difference from a tax perspective, either. 

When cashing out makes sense

Maybe money has gotten tight in your world, but you don't want to liquidate your investments or raid your savings account. In that situation, cashing out your dividends would be a perfectly reasonable thing to do. And it won't hurt you from a tax perspective compared to reinvesting that money.

Dividends are generally taxed at a more favorable rate than ordinary income. If you're single earning up to $40,400, you actually fall into the 0% tax bracket for taxes on qualified dividends (most dividend payments fall into this category). And if you're single with an income of $40,401 to $445,850, your tax rate on dividend income is 15%.

But those taxes will apply whether you reinvest your dividends or not. So don't assume that cashing out will hurt you tax-wise.

The one way you might lose out

Cashing out your dividends could make sense. But remember, in doing so, you miss out on the chance to reinvest that money and grow it into a larger sum. 

Cashing out $40 in dividend payments to cover a bill may not seem like a big deal. But over the past 50 years, the stock market's average return, as measured by the S&P 500, has been 10% before inflation. So if you were to reinvest $40 at a 10% return over 40 years, you'd grow it into about $1,800.

But still, if you have your reasons for cashing out your dividends, then so be it. And you could always cash out those dividends now, but make a plan to begin reinvesting them once your circumstances change. 

Most brokerage accounts will actually let you set up an automatic dividend reinvestment plan if you so choose. That way, you won't even have to think about it.