What is a dividend reinvestment plan?
One of the ways investors can earn profits from their investments is through dividends. To share wealth, some companies pay investors regular payments, known as dividends, when they make enough money to cover basic expenses.
There are many ways you can use these funds. Some investors may choose to pocket the money, especially if they have other pressing financial needs. But investors who are in it for the long haul might choose to reinvest their profits back into the company and give their money a chance to continue growing and earning interest, and it’s common for companies to do this through dividend Facilitate reinvestment plans (DRIP).
What is a DRIP?
A DRIP is a plan that allows investors to invest any dividends they receive back into the company’s stock — usually at a discount. It’s important to note that while this is a way for long-term investors to put even more money into their investments at a lower cost, those investments are still taxable (more on that later).
There are three main types of dividend reinvestment plans:
- Company operated DRIP: When a company runs its own DRIP and there is a specific department that manages DRIP plans.
- Third Party Operated DRIP: To save cost and time, some companies outsource their plans to third parties who take care of the entire plan.
- Broker operated DRIP: Some companies may not offer a DRIP at all, but brokers may offer investors a DRIP on some investments. In a broker-operated DRIP, brokers buy shares on the open market. Brokers may or may not charge a small commission for buying DRIP stock.
How do DRIPs work?
DRIPs work by reinvesting a set amount of dividends earned on the day they are normally paid. “You buy additional fractions of the shares on the day the dividend is paid,” says Philip Weiss, financial advisor and founder of Apprise Wealth Management. “The term can apply to any automatic arrangement that allows you to reinvest the dividends you receive into an account with a brokerage or investment company.”
This type of plan implements an investment strategy known as dollar-cost-averaging, in which investments are made in equal amounts at regular intervals, regardless of how the stock market is performing. For investors who find it difficult to keep their hands off their portfolio when the market is choppy, DRIPs can not only help automate investing, but also help spread some of the risk taken by continuously investing invest no matter what the market is doing.
Pros and cons of DRIPs
Pro: DRIPs are a way to automate your investment strategy. Choosing to have your dividends automatically reinvested puts one less financial task on your list. It also keeps you accountable for your long-term goals, even when the market is shaky and you might be tempted to react in the moment — a move that could potentially cost you more in the long run.
Pro: Shareholders can get a discount. DRIPs can help you reduce costs. “Some companies allow you to buy stock at a small discount through a DRIP [of] 1-10%,” says Weiss.
Cons: Shareholders could end up paying higher share prices. Because stocks are bought automatically, investors may invest at a time when prices are on the high end.
Cons: DRIP plans could throw your portfolio off balance. Overexposure to a particular company could hurt you in the long run if your portfolio doesn’t have a good mix of assets.
How DRIPs affect your taxes
DRIPs can be beneficial to investors in a number of ways. But there are still tax implications even if the funds go straight back to the company you invested in.
“Under the tax rules, whenever an investor has an election to receive a cash dividend or additional shares, the shareholder is taxed on the present value of the dividend,” Weiss said. “Reinvested dividends are taxed in the same way as cash dividends. But the amount of the dividend is added to your base in the shares. This means you have a smaller profit (or larger loss if the investment works against you) if [or] if you sell the shares in the future.”
take that away
DRIPs can offer long-term investors a way to save money by continuing to invest in the same company over time. However, it is important to balance your long-term goals with your short-term needs to determine if attending a DRIP makes sense for you.
