What Is A DRIP (Dividend Reinvestment Plan)?
Reinvesting stock dividends has its advantages and disadvantages. Find out how a dividend reinvestment plan (DRIP) works, see an example, and determine if it's right for you.
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What Is Dividend Reinvestment?
Dividend reinvestment occurs when an investor elects to have investment dividends buy more shares of the investment, rather than receive the dividends in cash or check. Investors who choose to reinvest their dividends are typically looking for long-term growth of their investment, such as a stock, mutual fund or exchange-traded fund (ETF).
What Is a DRIP?
DRIP stands for 'dividend reinvestment plan', which is a program that allows an investor to have stock or fund dividends automatically used to purchase more shares of the dividend-paying instrument, rather than sent to the investor as cash. Since dividends are typically paid on a periodic basis, such as quarterly, a DRIP stock takes advantage of dollar-cost averaging.
Important: Investors should note that dividends reinvested with a DRIP plan are taxable to the investor as income, just as dividends received in the form of cash or check. Qualified dividends are taxed at a 20%, 15%, or 0% rate, depending on the investor's federal income tax bracket.
Example of a Dividend Reinvestment Plan
For a DRIP example, let's say an investor owns 100 shares of a company's stock and has elected to have dividends reinvested. The company announces a $0.20 per share quarterly dividend and the stock price is $20 per share at the time of the dividend.
Here's the calculation for this DRIP stock example:
100 shares x $0.20 dividend = $20 reinvestment to buy 1 share at $20/share
Instead of receiving $20 in cash, the investor receives 1 additional share of stock.
Important: Investors should note that a DRIP reinvestment can result in the purchase of fractional shares. Based upon the above example, if a shareholder owned 100 shares of company stock, the dividend payout was $0.20 per share, and the share price at the time of the dividend was $22, the dividend would buy 0.91 share, or slightly less than one additional share for the investor.
Advantages of Using a DRIP
- Simplicity: A DRIP program set up directly with the issuing company or dividend reinvestment through a brokerage is easy to set up and maintain.
- Dollar-cost averaging: Since a DRIP program involves automated purchases over regular intervals, the reinvestment in a DRIP stock or fund takes advantage of dollar-cost averaging (DCA), which increases an investor's holdings at varying entry prices.
- Compounding: Reinvesting dividends can enhance the compounding effect of the investment. As the number of shares increase, each subsequent purchase will increase future dividend payments due to the additional shares purchased through the DRIP.
Disadvantages of Using a DRIP
- Potential for income taxes: Unless an investor establishes dividend reinvestment within a tax-advantaged account, such as an Individual Retirement Account (IRA), the dividends from a DRIP stock or other dividend-paying investment are taxable as income to the investor in the calendar year they are distributed, even when immediately reinvested.
- Tracking cost basis: A DRIP can complicate the process of keeping tax records. Each instance of dividend reinvestment will have its own cost basis for capital gains tax purposes, which is generally based upon the purchase price and any associated fees or commissions, if applicable.
- No control over timing of purchases: The investor is not able to choose the reinvestment schedule with a DRIP. For example, many dividend-paying stocks have a quarterly payout frequency on dividend payment and the reinvestment will occur on this same schedule.
How To Start a DRIP
Investors may establish a DRIP directly with the issuing company of the stock or they may choose to have dividends reinvested through the brokerage company where their investment account is held. The companies or brokerage offering DRIP plans typically do not charge any additional fees or commissions to the investor.
Bottom Line
There are multiple benefits of using a DRIP, including simplicity of implementation, dollar-cost averaging, and compounding. However, dividend reinvestment has some disadvantages, such as taxes and complexity involved with tracking cost basis. Investors are encouraged to do their own research before considering a DRIP stock for their own portfolio.
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