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I am 22 and just opened a Roth IRA from Vanguard. I am putting 5.5K a year but I was wondering if someone can give me pros and cons for what to do with my dividends and capital gains?

The two options Vanguard gives me are "Reinvest" and "Transfer to your money market settlement fund" (which I don't even understand what it means).

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The reinvestment of dividends and capital gains is a very significant portion of investment gains over the years. This creates a compounding effect on your gains. You should almost certainly reinvest to help the account grow, until you are retired and want to withdraw some cash. Placing them in a money market account just builds a pile of uninvested cash.

  • Does the amount that you reinvest count against the annual contribution limit? – cxrodgers Mar 8 '18 at 19:52
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    @cxrodgers Nope, reinvested dividends do not count toward your contribution limit. finance.zacks.com/… – Taylor Edmiston Apr 21 '18 at 18:11
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Older folk might wish to let the dividends and cap gains be paid in cash, and use that cash towards their RMDs (required distributions). If you are investing in mutual funds and wish to keep adding to the funds you've selected, the reinvestment is a simple way to avoid having to visit the account and make a new purchase. In other words, you invest $5500, buy the fund, and X years from now, you simply have more shares of the fund but no cash o worry about. The pro is as mentioned, and the con is really for the 70-1/2+ people who will need to take their RMDs. (Although even they can take the RMD in kind, as fund shares)

  • Depending on how people who need to take their RMDs take their RMDs (single annual lump sum? quarterly distributions?), reinvestment of dividends and capital gains might still make sense. – Dilip Sarwate Jul 19 '15 at 20:27
  • @DilipSarwate - I've written about the "in kind" distribution, but many don't get it. Having the cash in the account makes sense for many. But you are right. The two issues are actually unrelated. – JoeTaxpayer Jul 19 '15 at 21:36
  • What I meant was that mutual fund shares held in an IRA account can be sold and the proceeds sent to the account owner as a distribution from the IRA at the desired time. There is no need to hold the dividends and capital gains paid by the mutual fund as cash within the IRA until it is time to take a cash distribution from the IRA account, and of course even lesser need if the distribution from the IRA account will be taken as mutual fund shares as a in-kind distribution. – Dilip Sarwate Jul 20 '15 at 2:01
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TL; DR version of my answer: In view of your age and the fact that you have just opened a Roth IRA account with Vanguard, choose the Reinvest Dividend and Capital Gains distributions option.

If Vanguard is offering an option of having earnings put into a money market settlement account, it might be that you have opened your Roth IRA account with Vanguard's brokerage firm. Are you doing things like investing your Roth money into CDs or bonds (including zero-coupon or STRIP bonds) or individual stocks? If so, then the money market settlement account (might be VMMXX, the Vanguard Prime Money Market Fund) within the Roth IRA account is where all the money earned as interest on the CDs or bonds, dividends from the stocks, and the proceeds (including any resulting capital gains) from the sales of any of these will go. You can then decide where to invest that money (all within the Roth IRA). Leaving the money in the settlement account for a long time is not a good idea even if you are just accumulating the money so as to be able to buy 100 shares of APPL or GOOG at some time in the future. Put it into a CD in your Roth IRA brokerage account while you wait.

If your Roth IRA is invested only in Vanguard's mutual funds and is likely to remain so in the foreseeable future, then you don't really need an account with their brokerage. You can still use a money market settlement fund to transfer money between various mutual fund investments within the Roth IRA account, but it really is adding an extra layer of money movement where it is not really necessary. You can sell one Vanguard mutual fund and invest the proceeds into another Vanguard mutual fund or even into several Vanguard funds without needing to have the funds transit through a money market account. Vanguard calls such a transaction an Exchange on their site. And, of course, you can just choose to reinvest all the dividends and capital gains distributions made by a mutual fund into the fund itself. Mutual funds allow purchases of fractional shares (down to three or even four decimal places) instead of insisting on integer numbers of shares let alone round lots of 100 shares. All this, of course, within the Roth IRA.

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In case other people arrive at this page wondering whether they should enable automatic reinvestment of dividends and capital gains for taxable (non-retirement) accounts (which is what I was searching for when I first arrived on this page):

You might want to review https://www.bogleheads.org/wiki/Reinvesting_dividends_in_a_taxable_account and http://www.fivecentnickel.com/2011/01/26/why-you-shouldnt-automatically-reinvest-dividends/.

The general idea is that--assuming you plan to regularly manually rebalance your portfolio to ensure that all of the "pieces of the pie" are the relative sizes that you want--there are approaches you can use to minimize taxes (and also fees, although at Vanguard I don't think that's a concern) if you choose a "SpecID cost basis" and manual reinvestment.

Then you can go to "Change your dividends and capital gains distribution elections" at https://personal.vanguard.com/us/DivCapGainAccountSelection.

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