401(k) Dividends: How Do They Work?

Are you investing for retirement in your 401(k) and wondering about the meaning of the dividends from your mutual and exchange traded funds (ETFs)?

At first, investing concepts may appear a bit confusing, but a few quick examples will have you on your way to understanding what dividends are and how they work in your 401(k) account. Ultimately, you’ll learn how to maximize dividends for more ETF shares.

Investing basics

As a quick refresher:

• Investing is a strategy to own publicly traded companies with stock funds, and to lend money to companies and governments with bond funds.

• You benefit by participating in the growth of the economy.

• Ultimately, your money will likely earn greater returns from investing than if you kept it in a savings account.

• Unlike regular bank savings accounts, investments in stock and bond funds go up and down in value.

What are dividends?

When investing, your money grows in value in two ways: first, the value of the stock or bond fund may increase in value from your original purchase price.

An example scenario:

• You buy 100 shares of Vanguard Total World Stock ETF (VT) on January 2, 2013 for $46.51.

• On January 4, 2016, the VT share price is $55.97.

• During those 3 years, VT’s share price increased 20% [(55.97 – 46.51)/46.51)].

But in addition to capital growth, investors in VT also received dividend payments.

A dividend is a payment made by a corporation to its shareholders. This money typically comes from the profits of the company. There are many companies included in mutual or exchange traded funds, such as VT. The fund administrator combines all of the company’s dividend payments and pays you a proportion of the dividend payments based upon the number of fund shares that you own. The dividends are paid according to a specific schedule, typically quarterly, bi-annually or once per year.

In 2015, the Vanguard Total World Stock ETF paid dividends to its shareholders in March, July, October, and December to fund owners who bought the ETF at least a week before (called the ex-dividend date) the dividend payment date. In 2015, the total VT dividend payments were $1.41 per share. So, if you bought 100 shares of VT on January 2, 2015 for $57.86 per share, your investment value on the purchase date was $5,786 ($100 * $57.86), less a small commission payment. Throughout 2015 you also received $141.00 (100 * $1.41) in dividend payments for a 2.44% (141/5786) yield. And that’s the benefit of receiving a dividend! Regardless of whether the investment goes up or down, you receive the dividend payments.

Let’s assume you would rather take your dividend payments in additional shares, instead of cash. Here’s how dividend reinvestment works.

What is dividend reinvestment?

I remember buying my first mutual fund many years ago. The stock broker from whom I bought the fund asked if I wanted to reinvest the dividends. The concept made no sense to me, so he went on to explain dividend reinvestment along with its potential benefits. Simply put, reinvesting dividends allows you to buy more shares of the fund, without investing any of your own money.

Let’s go back to your 100 share purchase of VT on January 2, 2015 for a total of $5,786. If you chose to reinvest your dividends instead of taking the cash payout, here’s the result:

• On March 25, 2015 VT paid out $0.314 per share in dividend payments.

• Since you own 100 shares, the value of your dividend payment was $31.40.

• Instead of taking the cash, you instructed your investment account manager to reinvest the dividend check in additional share(s) of the VT ETF.

• On March 25, your $31.40 dividend payment purchased .525 share, or a bit more than half a share. That share was then added to your total 100 share count.

• Now you own 100.525 shares of VT and at the current $59.82 price, your investment value increases to $6,013.41 (100.525 * $59.82).

The chart below shows how your share count grows with each dividend payment as well as the total value of your investment in VT at the end of one year. Notice that on January 2, 2015 the VT ETF price was $57.86 and on December 31, 2015, the VT ETF price fell to $56.93. In spite of the decline in share price, your total investment value increased from $5,786 to $5,832.48 due to your increased share count.

As you reinvest your cash dividends in additional shares, your investment value may increase, even if prices remain stable.

Now you understand what a dividend payment is as well as the impact of squirreling away dividend payments as reinvestments in order to buy more fund shares. But how do dividends work in your 401(k)?

How do dividends work in your 401(k)?

The simplest answer to this question is, “It depends on whether you elect to take cash (payments) or shares (reinvestments)”. If your 401(k) account is managed by your employer through Human Interest, then your dividends are automatically reinvested in additional shares via their built-in investment advising feature. Human Interest chooses to reinvest your dividends into more shares because it is a cost effective way of increasing your total share count, since there are no transaction or commission costs for reinvesting dividends.

Other 401(k) providers will have different policies. Some 401(k) firms will give you a choice; take the dividends in cash or reinvest them in additional shares.

So, if you’re wondering how dividends are treated in your company’s 401(k) plan, the simplest way to find out is to either call the company 401(k) representative, review the information on the website or look at plan documents.

Whether you take a cash distribution from your fund or reinvest the dividends in additional shares, you’ll profit from the added value of the dividend payment.