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Dividend reinvestment plans (DRIPs) have been introduced as a way to entice shareholders to reinvest their dividend payments into the business to reduce the cost of raising capital and strengthen the balance sheet.
DRIP programs are considered a win-win situation as the company benefits from lower-transaction-costs capital while shareholders typically get more advantageous prices for buying shares through a company-sponsored DRIP.
In this article, we explain in detail what DRIPs are and how they work so you can decide if you would like to enroll in these programs when investing in individual stocks.
What Is Dividend Reinvestment?
Let’s start with the basics. A dividend is a payment extended by a company to its shareholders and it comes out of the earnings produced by the business during a certain period.
These distributions are usually paid on a quarterly basis and companies tend to follow a certain policy that allows shareholders to know in advance how much money they will be receiving in the next three months or so as long as the company’s financial conditions remain favorable.
Dividend reinvestment consists of taking the money received from these distributions to buy additional shares in the same company with the expectation that the business will continue to perform positively in the future.
As a result, shareholders should benefit from the compounded interest produced by this activity, meaning that their gains are multiplied exponentially as they continue to reinvest dividends down the road.
In a nutshell, a Dividend Reinvestment Plan or DRIP is a tool to automatically invest the proceeds received from dividend stocks in the same company.
How Does Dividend Reinvestment Work?
In practice, dividend reinvestment can be performed following different paths. The first, and perhaps easiest, way to reinvest the dividends received from a company is to enroll in its in-house dividend reinvestment plan (DRIP). There are many benefits involved in taking this road and we will discuss them in detail later in the article.
On the other hand, some brokers may offer the possibility to reinvest dividends automatically once distributions have been received. In this case, the broker will be responsible for buying the exact number of shares that correspond to the dividend payment and this results in fractional ownership.
Finally, an investor can take a do-it-yourself approach that involves buying shares for however much money he or she receives via a dividend payment.
Each of these approaches has its advantages and disadvantages, most of which are associated with the fees paid in the process and the price at which the new shares will be bought.
How Does a Dividend Reinvestment Plan Work?
A dividend reinvestment plan (DRIP) is set up by a company to entice investors to pour the funds they have received from dividends back into the business to further strengthen its balance sheet.
These programs can be administered by either the company or a third party and they typically offer shareholders some rewards for enrolling.
For example, a company could offer to sell the shares that will be purchased via the DRIP at a lower price compared to the market price on the day that the dividend is distributed.
How to Reinvest Dividends using DRIPs
DRIPs work differently depending on the company that you are investing in and who manages the program. Here’s an overview of how DRIPs are typically set up by corporations in the United States.
Large corporations — typically large and mega caps — administer their DRIPs as a way to remain in close contact with shareholders. These programs usually feature a discounted price for the shares issued as part of the DRIP and they result in savings to the shareholder as they prevent them from paying transaction fees.
Some companies outsource the administration of their DRIP to a third party typically known as the transfer agent. These intermediaries are responsible for allocating the shares to those who have enrolled for the DRIP.
Keep in mind that these companies may charge a fee for providing this service and that could weigh on the performance of the DRIP strategy over time.
Some brokerage firms nowadays allow stockholders to enroll for a broker-administered DRIP for a selected group of companies. These brokers will typically buy and distribute the number of shares required to reinvest the proceeds from the dividend back into the company and fractional shares will usually be issued to complete the purchase.
In most cases, DRIP-related transactions do not generate a trading fee or commission. However, investors should make sure that this is the case for whatever broker they choose to work with.
For companies that do not offer an in-house DRIP or that are not eligible for a broker-administered DRIP, investors will have to adopt a DIY approach to be able to fully reinvest the proceeds back into the business.
This is not the most convenient or cost-effective solution as trading fees will usually apply to the purchase of these additional shares. However, since most brokers have slashed their fees and commissions nowadays, the cost of a DIY approach has gone down significantly.
On the other hand, the investor will not enjoy the benefits that are typically extended by company-sponsored DRIPs, such as a lower share price.
Something to keep in mind is that the dividends paid into DRIPs are taxed as ordinary dividends.
Cash vs. Reinvested Dividends
In finance, the cost of moving money from one asset to the other is typically known as the opportunity cost and it consists of the difference between the gains that would have been obtained if the money stood at Asset A versus the gains that the investor will receive from pouring his/her money into Asset B, minus transaction costs.
When it comes to dividend reinvestment, the dilemma that most investors face is whether they should take the cash and invest it somewhere else or spend it versus reinvesting the funds into the company.
The benefit of taking the cash is that the investor can pursue more profitable activities or use the money to cover certain other financial needs while the risk or cost involved is the gains that he/she will be leaving on the table as a result of pulling the money out.
Meanwhile, the benefit of reinvesting dividends is that the money will continue to produce gains in the future and this results in compounded earnings. Meanwhile, the risk involved would be that the company suspends its dividend payments or that the stock price declines significantly as a result of a deterioration of the business’s fundamentals.
Advantages of DRIP Investing
- Reinvestment plans help investors put their portfolios on auto-pilot.
- It can be a great way to compound returns over long holding periods.
- It is a perfect complement to dollar-cost averaging (DCA).
- Investors can avoid trading fees if DRIPs are set up via company or broker-sponsored programs.
- Some company-sponsored DRIPs offer a marked-down price for the new shares.
Drawbacks of DRIP Investing
- Some company-sponsored DRIPs may establish a minimum number of shares that can be purchased directly from the corporation.
- Trading fees and commissions may reduce gains over time for DIY DRIPs.
- The portfolio may still need to be rebalanced from time to time.
- Taxes on dividends still have to be paid despite the funds being reinvested.
DRIP Investing on Taxes
Dividends are considered taxable income in the United States regardless of whether they are reinvested in the company or not. That said, some dividends qualify as long-term capital gains and the tax rate applicable to those is usually lower than other categories.
Overall, the best way to avoid being taxed on the dividends received by companies is to hold the securities in a tax-deferred account, such as a 401(k) or an individual retirement account (IRA).
Frequently Asked Questions on DRIP Investing
These are answers to some of the most frequently asked questions we get on the topic of DRIP investing.
Should I Reinvest Dividends?
As a rule of thumb, if you are a long-term investor, reinvesting dividends by using a DRIP makes sense as you can benefit from the lower transaction fees and discounted share price, if applicable.
On the other hand, it is important to note that, over time, your portfolio may deviate from the original asset allocation mix as a result of enrolling for DRIPs. If that happens, you will still have to rebalance the portfolio periodically. This implies selling a portion of the shares you have purchased with these dividends to meet your portfolio’s initially conceived allocation.
What Are the Benefits of DRIPs?
The main benefits of DRIPs are discounted share prices typically offered by company-sponsored programs, lower trading fees, and compounded gains.
When Is Best to Reinvest Dividends?
Trying to time the market to identify when you should reinvest your dividends can be time-consuming and largely ineffective. Therefore, the best time to reinvest your dividends, in most cases, is the moment when they are distributed.
Since dividends are distributed periodically, you will be buying shares of the company at different points in time and that should smooth your cost basis over time as the price of the stock will probably be different at every instance.
Dividend reinvestment is a practice that rewards the long-term investor in the form of compounded gains. If you are willing to hold the shares of the company, you will probably feel comfortable with pouring more money into it once your distributions come in.
That said, keep an eye on your portfolio’s asset allocation mix to make sure the weight assigned to each asset class or individual stock does not deviate too much from the target.
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.