Dividend Reinvestment Plan (DRIP)
An investment strategy that allows shareholders to automatically reinvest their dividend earnings to purchase more shares of the same company's stock
What Is A Dividend Reinvestment Plan (DRIP)?
A Dividend Reinvestment Plan (DRIP) is an investment strategy that allows shareholders to automatically reinvest their dividend earnings to purchase more shares of the same company's stock.
This helps compound wealth over time without receiving cash dividends, potentially increasing the overall investment value. While DRIPs may not incur additional company fees, some brokerages may charge fees for participating in DRIPs or for dividend reinvestment.
However, reinvesting dividends must still be reported as taxable income despite not directly receiving the cash. Some exceptions include tax-advantaged accounts such as an IRA.
Reinvesting cash dividends through a DRIP can capitalize on the power of compounding, as dividends are used to purchase additional shares, leading to the accumulation of shares over time and potential growth in investment value.
There are three types of DRPs:
- Through the company
- Through a brokerage
- Through a third-party transfer agent
This article will help you determine whether a DRP suits your investing goals. DRPs are alluring to long-term investors because compounding requires a long time horizon.
Key Takeaways
- A Dividend Reinvestment Plan (DRIP) allows shareholders to automatically reinvest dividends to purchase more shares of the same company's stock, potentially increasing overall investment value over time.
- DRIPs can be company-operated, broker-operated, or third-party-operated, each with varying fees and accessibility.
- DRIPs enable compounding of wealth over time, with dividends reinvested to purchase additional shares, often at a discount.
- Enrolling in a DRIP with companies like IBM or Pepsi illustrates the potential benefits of compounding through dividend reinvestment.
- DRIPs offer advantages such as discounts, compounding, and automation but have potential drawbacks like dilution, limited control over purchase prices, tax reporting complexities, and associated fees.
Maximizing Returns with Dividend Reinvestment Plans (DRIPs)
Investments aim to maintain, ideally increase, the value of the original amount you put in. Dividend reinvestment plans, also known as DRIP, or DRP, enable your money to work for you.
When you receive a dividend, you have two options for spending the money: cashing out or reinvesting. Without enrolling in a dividend reinvestment plan, dividend cash will be sent directly to your bank account or as a check.
This plan automatically reinvests income from a stock's dividends to buy more company shares. This transaction occurs on the company's dividend payment date (which could be quarterly, biannually, or annually).
Cash dividends can be reinvested in additional shares, depending on the stock's current market price. As of 2020, over 1,000 companies offer some form of a dividend reinvestment plan (DRIP), double the number of companies that offered a DRIP a decade ago.
The shares purchased through a company's DRP generally come from the company's reserve and, therefore, are not marketable through stock exchanges such as the New York Stock Exchange (NYSE).
Note
Some DRIPs may require a minimum purchase, often offering shares commission-free and at a discount to the current market price of the stock.
Types of Dividend Reinvestment Plans
Dividend reinvestment plans can be a wise method of repurchasing new shares of a stock, but the fees and accessibility of the program can vary depending on the company.
The decision to set up a program is at the company's discretion; if they do not want to set one up, brokerages and third parties often will. Many publicly traded companies offer a reinvestment plan in some way.
If a stock does not have a reinvestment program, you can deposit the dividend income into your brokerage account and manually purchase additional shares.
1. Company-Operated Reinvestment Plan
Many large, publicly traded companies manage their DRPs through their investor relations team. The company's reserve of shares is purchased by shareholders through reinvestment and generally comes at a significant discount.
Additionally, these plans have no commissions because the intermediary, the broker, is removed from the transaction process.
This is appealing to long-term shareholders because there is no commission on each reinvestment which can occur multiple times a year depending on how often a company pays out its dividend.
This allows shareholders to capitalize on compounding without paying fees.
2. Broker-Operated Reinvestment Plan
Unlike the company-operated program, the broker acts as the intermediary. This can be advantageous if the company does not have its own DRP, but you still want to reinvest the dividends.
Your brokerage buys the shares on the open market to reinvest your dividends. However, your broker may or may not charge a commission for this service, so it's essential to research associated fees with broker-operated DRPs.
Note
Enrolling in a reinvestment plan through your brokerage can also simplify the process. Unlike the company-operated DRP, you will not have to activate automatic reinvestment for every individual stock.
3. Third-Party-Operated Reinvestment Plan
This type of DRP occurs when the company outsources the reinvestment of dividends to a third party. Companies may do this if running their own DRP is too costly or time-consuming for their investor relations team. This is usually the case with smaller companies.
This service may come with a fee or commission, which can vary and may not necessarily be similar to those of brokerage-operated DRPs.
Real-World Example of a DRIP
For instance, let's say that you own 1,000 shares of International Business Machines (IBM), and the stock currently trades at $100 per share. The quarterly dividend is $0.20 per share, so the annual premium is $0.80 per share.
Before setting up a DRIP for IBM, you would have received $200 (1,000 shares * $0.20) as a cash dividend into your brokerage account from the dividend.
However, with the plan, you would now own 1,002 shares of IBM. This is because the $200 would be reinvested to purchase two more shares of IBM at $100 per share. Note that if the dividend were not precisely $200, there would also be a purchase of fractional shares.
A similar pattern would occur each fiscal quarter that you receive a dividend, so the number of shares you have will increase exponentially.
Note
A real-world example is if you had invested $2,000 in Pepsi in 1980 and had enrolled in a DRIP. That $2,000 would be worth more than $150,000 by 2005. The 80 shares you started with could have grown to 2,800 by 2005 through dividend reinvestment, illustrating the potential benefits of enrolling in a DRIP.
Advantages of a Dividend Reinvestment Plan
Like many investing techniques, enrolling in a reinvestment plan has advantages and drawbacks. Consult your investing profile and current financial situation to decide if a DRIP suits you.
Let's take a look at the advantages below:
Advantages for Investors
Some of the advantages are:
- Many large companies offer a discount on the market price for plan shareholders. Some companies offer between 1% and 10% off the market price
- These help investors capitalize on compounding, allowing the investment to grow exponentially faster
- Many reinvestment programs do not charge a commission, so shareholders can save on transaction costs with DRIPs
- Some DRIPs allow fractional investing, enabling every dollar to work for you in the market
- Once you set up a DRIP, the reinvestments are automated, making reinvesting accessible and easy. This automation also removes emotions from the investment decision, which can be many investors' Achilles heel
- These can reduce your risk because of dollar-cost averaging. In addition, consistent investment over time despite the market conditions eliminates the need to time the market to ensure you don't have the security at too high a price
Advantages for Companies
The advantages are:
- Reinvestment plans can establish a base of loyal shareholders with a long investment horizon. This can alleviate some of the stress of poor performance because these investors will likely not sell their shares despite increased volatility
- DRPs can generate more capital for a company when it sells shares where the dividend cash is reinvested
Disadvantages of a Dividend Reinvestment Plan
Some of the main disadvantages for Investors are:
- Shares can be slightly diluted due to DRPs because more claims become outstanding in the market when more shares are sold. Investors who do not enroll in a reinvestment plan could see their ownership diluted
- Automatic reinvestment occurs on each dividend payment date, potentially limiting an investor's control over the price they pay for the stock
- It can be time-consuming and sometimes challenging to keep track of the dividend income for tax reporting purposes
- An individual's portfolio may need constant rebalancing if a few dividend companies dominate it and the individual wants to maintain diversification. Additionally, consistently selling a stock can have more tax implications
- Some reinvestment programs come with a fee, including some broker-operated DRPs and third-party-operated DRPs
- Shares purchased directly through a company's DRIP are typically from existing shares held by the company and can be sold on the open market, potentially affecting liquidity
- Some DRPs require a minimum investment (either a dollar amount or a specific volume of shares)
Dividend Reinvestment Plan (DRIP) FAQs
It's essential to understand your investing profile and your goals for your securities. Dividend reinvestment plans are more suitable for long-term investors, depending on how soon you will need the money you have invested.
For example, younger investors may be more inclined to enroll in a reinvestment plan because they may not need the funds they have invested as soon and can capitalize on compounding.
This compounding can help offset inflation and prevent the erosion of your purchasing power.
On the other hand, an individual near retirement may want to use the dividends as a stream of income to supplement their retirement savings.
Additionally, if a company is not performing well, it may be wiser to hold onto the cash and observe the stock's performance.
Dividends are considered taxable income whether the money is deposited in your account or is reinvested.
Most dividends paid by large companies are considered qualified dividends. As a result, these dividends are taxed at lower rates than ordinary income tax rates, typically the same as long-term capital gains tax rates.
The tax rate for qualified dividends depends on your adjusted gross income. The higher your income, the more taxes you have to pay. However, the tax rate for qualified dividends is lower than the tax would be if it were from your traditional income.
Tax-advantaged accounts such as a Roth IRA offer tax-exempt withdrawals in retirement, but contributions are made with after-tax dollars and are not tax-deductible.
ETFs can be valuable DRP candidates because they provide diversification and generally have low expense ratios. In addition, the dividend is unlikely to change or be eliminated significantly.
Large blue chip companies are generally more conservative investments for individual stocks because you can rely on a dependable dividend payout and less volatility. This is particularly inviting to long-term investors looking to use compounding.
The Dividend Aristocrats is one stock market index that contains companies that have consistently increased their dividends over the past 25 consecutive years.
There are no "best" DRP stocks, as investing in the stock market always has risks. Thoroughly research investment options that best fit your investing profile and financial situation.
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