I do not set my funds to reinvest dividends and capital gains - I redirect them to money market funds instead.
Here's the quirk: Vanguard cannot do this if the target fund (which I will reference as the money market fund VMMXX as according to my settings) has a zero balance. They warn you about this if you try to change the reinvestment settings and VMMXX has a zero balance at the time. However, they do not warn you if you let the VMMXX balance drop to zero after you've changed the settings.
I had dividends from VTSMX in my traditional IRA set to be direct to my money market fund VMMXX in the tIRA. However, VMMXX had a zero balance. Hence, Vanguard didn't direct my dividends there. They instead cut me a check.
Now if this had occurred in a Roth or taxable, that's not really a problem. Yes, I just decreased my tax advantaged space. But, the dividend amount wasn't much at all - $23.23 before tax withholding. Unfortunately, this occurred in a tIRA. Meaning this is now an early withdrawal from a tIRA, which would be subject to a 10% penalty. This would become a reporting headache, all for a measly $23.23
Fortunately, there is the rollover rule. When you wish to transfer your IRA from one custodian to another, you have two main options: a custodian to custodian transfer where you never come in direct contact with the money, or a rollover via check. Custodian 1 cuts you a check, which you then have 60 days to deposit to an IRA at custodian 2 for it to not count as an early withdrawal from an IRA.
What's interesting is this rule can be used for a "rollover" from one IRA to the same IRA. As in, you can loan yourself IRA money for 60 days. But, to prevent this kind of abuse, the government ruled last year that you can only do a rollover via check once in a twelve month window, across all IRAs.
What this means for me is that because I haven't done a rollover via check in the past 12 months, I can deposit the $23.23 back into my IRA and the dividend payment will not count as an early withdrawal.
So, long story short, if you wish to redirect dividends to a money market account, the money market account needs a nonzero balance. There are no real consequences if you do this in a taxable account. In a Roth account, that means you're giving up tax advantaged space but it's no that big a deal since dividends by definition are only a fraction of your fund balance. In a traditional account, this can cause reporting issues which can be avoided by redepositing the pre-tax amount back into the IRA within 60 days, as long as you have not done a rollover by check in the past 12 months.
In case you're wondering why I redirect dividends and capital gains to VMMXX instead of reinvesting them:
- I might be tax loss harvesting at the time. Suppose I'm TLH'ing fund X. If so, I do not want to buy any shares of X in any of my accounts. Reinvesting dividends would cause me to automatically buy shares of X. Even though you cannot TLH funds in a retirement account, any purchases in them can cause wash sales of funds you're TLHing in the taxable account.
I could certainly set it to reinvest and then change it when I want to TLH, but I don't want to forget. I do get emails of transaction notices when I receive dividends to VMMXX, so I do remember to do something with it. - My asset allocation may be off from what I want. If that's the case, why keep reinvesting? I should direct my dividends towards the fund that is underallocated.
This reason is not all that compelling on it's own, but reason #1 is compelling enough and this one just makes the case stronger
