Two people own the same $100,000 portfolio. Same fund, same expense ratio, same dividend yield, same price return. The only difference is what they do on the day each dividend lands.
Path A reinvests every dividend. Path B takes every dividend as cash and spends it. Neither sells a share. Neither adds new money. Twenty-five years later, the two accounts hold the same asset at the same return — and they are not the same size.
This article builds the ledger for both paths, year by year, so you can open a spreadsheet, type in the same assumptions, and get the same numbers. If you disagree with an assumption, change the cell. The arithmetic doesn’t care.
The assumptions, stated before any number appears
Everything below is a model input, not a forecast. I am not predicting these returns. I am choosing them so the arithmetic is reproducible.
- Starting balance: $100,000, invested on day one of year 1.
- Dividend yield: 1.8% of the prior year-end balance, paid annually at year-end.
- Price return: 5.2% per year, applied to the balance before the dividend is added or removed.
- Total return: 7.0% per year (5.2% price + 1.8% dividend).
- Tax rate on dividends: 15%, applied to the dividend in the year received. This is the rate that applies to qualified dividends for many taxpayers in the middle brackets; the IRS notes that qualified dividends are ordinary dividends that qualify to be taxed at lower capital gain rates. Your own rate may differ.
- Taxes are paid from outside the portfolio in both paths, so the balance comparison is not distorted by selling shares to cover the bill.
- No shares are sold in either path. No new money is added.
- Dividends are paid annually. Quarterly payments would change the numbers slightly, not the shape of the result.
The 7% total return is a modeling choice. Historical S&P 500 data compiled by Aswath Damodaran at NYU Stern shows the index’s return includes both price appreciation and dividends, and the annual figures swing widely — 2008 was −36.55%, 2009 was +25.94%. A single smooth 7% line is a simplification. It is useful for seeing the mechanics of reinvestment. It is not a description of what any 25-year period actually feels like.
The mechanics, in three years
Year 1. The $100,000 grows 5.2% to $105,200. The dividend is 1.8% of the prior balance, or $1,800. Path A adds it back: $107,000. Path B removes it: $105,200, and $1,800 in cash leaves the account. The two paths are identical in year 1 except for where the $1,800 sits.
Year 2. Path A starts at $107,000. It grows 5.2% to $112,564. The dividend is 1.8% of $107,000, or $1,926. Path A ends at $114,490. Path B starts at $105,200, grows to $110,670, and pays a dividend of $1,893.60. Path B ends at $110,670, and $1,893.60 leaves the account.
Year 3. The gap widens. Path A’s dividend is now calculated on a larger base. Path B’s is calculated on a base that never received the first two dividends. By year 3, Path A ends at $122,504 and Path B ends at $116,425. Path B has also handed you $5,619.60 in cumulative cash.
That is the whole mechanism. The dividend is a percentage of the balance. Reinvest it, and next year’s dividend is calculated on a bigger balance. Spend it, and next year’s dividend is calculated on the balance you would have had anyway.
The year-by-year ledger
The table below shows selected years. The full 25-year table is reproducible from the same three inputs: prior balance, price return, dividend yield. In a spreadsheet, Path A’s ending balance in any year is prior_balance × 1.052 + prior_balance × 0.018, which simplifies to prior_balance × 1.07. Path B’s ending balance is prior_balance × 1.052, and the dividend prior_balance × 0.018 is withdrawn.
| Year | Age | Path A start | Path A dividend | Path A end | Path B start | Path B dividend (withdrawn) | Path B end | Path B cumulative cash |
|---|---|---|---|---|---|---|---|---|
| 1 | 40 | $100,000 | $1,800 | $107,000 | $100,000 | $1,800 | $105,200 | $1,800 |
| 2 | 41 | $107,000 | $1,926 | $114,490 | $105,200 | $1,894 | $110,670 | $3,694 |
| 3 | 42 | $114,490 | $2,061 | $122,504 | $110,670 | $1,992 | $116,425 | $5,686 |
| 5 | 44 | $131,079 | $2,359 | $140,255 | $122,471 | $2,204 | $128,831 | $10,086 |
| 10 | 49 | $183,846 | $3,309 | $196,715 | $157,788 | $2,840 | $166,009 | $27,321 |
| 15 | 54 | $257,853 | $4,641 | $275,903 | $203,330 | $3,660 | $213,903 | $51,678 |
| 20 | 59 | $361,653 | $6,510 | $386,969 | $262,000 | $4,716 | $275,624 | $84,326 |
| 25 | 64 | $507,283 | $9,131 | $542,693 | $337,570 | $6,076 | $355,130 | $126,747 |
At year 25, Path A holds $542,693. Path B holds $355,130 and has handed you $126,747 in cumulative cash. Add the cash back to Path B’s balance and you get $481,877 — still $60,816 short of Path A. That shortfall is the compounding the withdrawn dollars never did.
The gap is not a return difference. Both paths hold the same asset at the same 7% total return. The gap is entirely the arithmetic of a percentage applied to a smaller base, repeated for 25 years.
The tax layer, which is separate from the balance
Reinvested dividends are still taxable in the year received. The IRS is explicit: dividends are distributions of earnings and profits paid to stockholders, and qualified dividends are taxed at lower capital gain rates. Whether you take the dividend as cash or use it to buy more shares, the taxable event has already happened.
In this model, the 15% tax on Path A’s dividends totals $17,077 over 25 years. Path B’s tax totals $13,247. The difference — $3,830 — is the tax on dividends that Path A reinvested. If you pay that tax from outside the portfolio, as this model assumes, the balance comparison stands. If you pay it by selling shares, you introduce basis and holding-period questions that this table does not capture.
Two other tax details matter for anyone running this in real life. First, a taxpayer who receives dividends in significant amounts may be subject to the net investment income tax and may need to make estimated tax payments to avoid a penalty. Second, even if you never receive a Form 1099-DIV, you must still report all taxable dividend income. The form is a convenience, not the trigger.
One more distinction worth knowing: a return of capital is not a dividend. It reduces your adjusted cost basis in the stock. Once that basis reaches zero, any further nondividend distribution is a taxable capital gain. Most broad index funds do not distribute return of capital, but if you hold individual securities or certain funds, the line between dividend and return of capital matters for both your tax bill and your basis records.
What the historical record does and does not tell you
The S&P 500’s annual returns are not smooth. Damodaran’s dataset shows 2008 at −36.55% and 2009 at +25.94%. DQYDJ’s table, which uses a December-to-December monthly-average convention, shows 2022 at −14.99% and 2023 at +21.69%. The same page notes that the longest positive streak in its data is 10 years, 1947 through 1956.
None of that tells you what the next 25 years will do. It tells you that a single smooth 7% line is a modeling convenience. A real 25-year holding period will include years that look nothing like the table above. The table is still useful because it isolates the one variable you control: whether the dividend compounds or leaves.
If you want to see how a smaller, regular contribution interacts with the same compounding mechanics, the arithmetic in What a Ten-Dollar Weekly Bump Actually Does to Your Retirement Number uses the same year-by-year approach on a different input.
The decision rule
Path B is not a mistake. It converts a growing asset into a level cash stream. If you need the income, taking the dividend is a legitimate way to get it without selling shares. The claim here is narrower: over a 25-year horizon, the two paths produce materially different terminal balances, and the size of that difference is fully determined by the yield, the horizon, and the return assumption you choose.
If the 7% return assumption holds, the gap is six figures before you count the cash. If it doesn’t, the gap is different — but the direction is the same, because the mechanism is the same. A dividend reinvested is a dividend that gets to work again next year. A dividend spent is a dividend that doesn’t.
Open a spreadsheet. Put $100,000 in cell A1. Put 1.052 in B1 and 0.018 in C1. Drag the formulas down 25 rows. Change the yield or the return and watch the terminal balances move. That is the whole exercise. The number that matters is the one you get when you use assumptions you believe.
Frequently asked questions
Does reinvesting a dividend create a new tax lot?
Yes. Each reinvested dividend buys shares at that day’s price, and those shares have their own cost basis and holding period. When you eventually sell, you will need records for each lot. Most brokers track this automatically, but the burden of proof is yours if the records are ever questioned.
Is the 15% tax rate on dividends correct for me?
It depends on your taxable income and filing status. Qualified dividends are taxed at capital gain rates, which can be 0%, 15%, or 20%. Ordinary dividends are taxed at your ordinary income rate. The IRS publishes the brackets each year. The 15% figure in this model is a stated assumption, not a universal rule.
What if I reinvest some dividends and spend others?
The arithmetic is linear. You can model any split by running two columns: one for the reinvested portion, one for the withdrawn portion. The terminal balance will fall between the two paths shown here, in proportion to how much you reinvest.
Does the dividend yield stay constant in real life?
No. Dividend yields change as prices move and as companies change their payout policies. The 1.8% figure here is a fixed modeling input. A real portfolio’s yield will drift. The mechanism — reinvested dollars compound, withdrawn dollars don’t — holds regardless of what the yield does.
What about inflation?
This model is in nominal dollars. It does not adjust for inflation. A dollar in year 25 buys less than a dollar in year 1. If you want to see real purchasing power, you would need to deflate each year’s balance by a cumulative inflation factor. That is a separate calculation with its own assumption, and it does not change the comparison between the two paths — both are affected equally.