In the whole scheme of things, whether you reinvest capital gains and dividends or roll them into a cash position isn't going to make or break you as a financial planner. Nor will it be the determining factor in whether your clients can someday retire in style. Other aspects of the planning process, such as asset allocation, are more important. But sometimes it's the little details in this business that make for true excellence.

So what do you do with those dividends and those capital gains? Well, that depends. There are perfectly valid reasons for reinvesting and for taking cash.

"We reinvest all dividends and capital gains," says Frank Armstrong III, principal of Investor Solutions in Coconut Grove, Fla., and author of The Informed Investor: A Hype-Free Guide to Constructing a Sound Financial Portfolio (AMACOM, 2002). By reinvesting, of course, Armstrong means that all dividend payments and all realized capital gains are automatically ushered into purchasing additional shares of whatever investment generated the disbursements in the first place.

"If we need cash for a particular client, we create a synthetic dividend' by carving out a specific part of the portfolio," he says. "I'd rather pick and choose where I'm going to take cash from and how I'm going to rebalance than allow the funds' dividends, which are essentially random and uncontrollable, to determine how it gets done."

Reinvesting also limits transaction fees, Armstrong says. "By reinvesting automatically, we keep transactions to a minimum. Reinvesting is simply more economical and gives us more control."

Not so for Diane Pearson, director of financial planning with Legend Financial Advisors in Pittsburgh, who prefers to see the disbursements flow into her client's cash positions. "We feel quite stringent about it here," she says. "We do not reinvest dividends and capital gains. We have all such monies transferred into a money market account."

Pearson says her firm's advisers consider themselves "active managers, and if we just sat back and allowed dividends and capital gains merely to reinvest, we wouldn't be active managers anymore," she explains. "We want to be the ones to make the decision whether to add to a certain position. Adding to a position at the time when a dividend is issued or a capital gain is realized may not be the decision we want to make."

Moreover, funneling disbursements into cash gives her more flexibility to create a new position without having to sell an existing one, she says. And, "it gives us a cash pool from which we can take our management fees."

Can both Pearson and Armstrong be right? Both work at advisory firms with more than $200 million under management, both have many years of experience, and both argue their positions on this issue with clarity and passion.

Indeed, both advisers are backed by some heavy hitters from the world of finance. Christine Benz, associate director of fund analysis with the Chicago-based investment research firm Morningstar, favors reinvesting for reasons that have nothing to do with taxation, rebalancing, or cash flow.

"The conventional wisdom is on the side of reinvesting, and I suppose that it's sometimes worth challenging the conventional wisdom," she says. "But I believe that taking dividends as cash rather than reinvesting can be dangerous; it tends to focus too much attention on an investment's yield. Total return is what you should focus on." Also, she says, reinvesting "imposes discipline," stifling the temptation to spend incoming cash rather than invest it.

Walt Woerheide, Ph.D., professor of investments with The American College in Bryn Mawr, Pa., and author of Core Concepts of Personal Finance (Wiley, 2003), leans toward Pearson's point of view, especially for portfolios of individual stocks. "If you have a portfolio of individual stocks, one of your main goals should be to add diversification. So I say take the dividends as cash--you won't need to worry about capital gains distributions with individual stocks unless you sell them--and continually build up that cash so that you can buy new positions," he says.

"If you merely reinvest in a portfolio made up of individual stocks, you risk becoming too concentrated," he says. He's less emphatic about portfolios composed of mutual funds, where over-concentration is less of a concern. "But I still generally favor taking the dividends as cash," Woerheide adds. "Otherwise, you could wind up commingling new money with old, confusing cost bases, and possibly incurring an extra level of tax whenever you need to sell shares for cash. Building up cash from dividends and capital gains is much cleaner."

Mark Willoughby, CFA, CFP, and senior wealth manager with Greenbaum and Orecchio of Old Tappan, N.J., calls for cash disbursements--for diversification reasons. "We feel that reinvesting just doesn't make sense," he says. "If you have a better-performing--and subsequently overweighted--asset class that is also throwing off dividends, and you automatically reinvest those dividends, then you're moving further away from your target. Taking dividends as cash, on the other hand, will help to prevent such portfolio drift."

Further overweighting an already overweighted asset can also raise your tax bill when you sell, especially if the asset has posted additional gains, Willoughby says. "You'll be paying tax on the dividend regardless, so the difference may not be that big," he acknowledges. "But we do try to save the client whatever taxes we can." He adds that many of his firm's clients are older and in distribution mode, so distributing dividends and capital gains as cash more readily meets their needs.

The fact is that neither side is right or wrong. Each strategy serves different purposes and management styles. Jeffrey Bogue, for example, a CFP and fee-only financial planner in Wells, Maine, uses both options. He reinvests dividends and capital gains for some clients and rolls them into cash for others. "If a client is still in the accumulation phase, I generally reinvest," he says. "If a client is in the disbursement phase, I prefer to take the dividends as cash."

But there are no hard and fast rules, he says. "I'll make exceptions, for example, for individual stocks, where I really don't like to reinvest unless I have my thumb firmly on the cost basis."

Clearly, the issue of reinvestment isn't worth the investment of too much sweat. Choose one path or the other--or some combination of both--that you feel serves your clients best.

Caveat Emptor: What to Watch For

If you reinvest capital gains and dividends...

• Unless clients are making regular contributions to their portfolios, you may need to sell securities to raise cash or to open a new position. Check on the redemption fees for any mutual funds you sell-they can sometimes be substantial.
• Track cost basis carefully. If you need to sell a position to raise cash, consider working with your custodian to specify shares in order to avoid realizing capital gains.
• Figure out where your fee will come from because you may not be able to pull it out of the account. You can ask clients to write a check, but that's not as clean and easy. You need to invoice them and keep following up if the bill isn't paid.

If you don't reinvest...

• Don't let your cash position get too large, or it can become a drag on your performance.
• Make sure that large dividend-paying assets don't become too underweighted in your portfolios. (Remember that share prices drop after dividend disbursements.)

Either way, you'll need to buy shares whenever you want to increase a position, so be sensitive to trading costs, especially in smaller accounts.

Russell Wild is a financial journalist and a fee-only investment adviser based in Allentown, Pa. He sometimes reinvests dividends, and sometimes not. He wrote about international real estate investment trusts in the April issue.