One of the ways investors can start earning a profit from their investments is through dividends. As a way to share the wealth, some companies will pay investors periodic payments known as dividends when they’re earning enough money to cover their basic expenses.
There are a lot of ways you can use these funds. Some investors might decide to pocket the money, especially if they have other pressing financial needs. But investors who are in it for the long game might choose to reinvest their earnings back into the company and give their money the chance to continue to grow and compound, and it’s common for companies to facilitate this through dividend reinvestment plans (DRIP).
What is a DRIP?
A DRIP is a plan that lets investors reinvest any dividends they receive back into the company’s stock automatically. Instead of taking a dividend as cash, it’s used to purchase more shares of the stock—usually at a discount.
There are a three main types of dividend reinvestment plans:
- Company-operated DRIP: When a company operates its own DRIP and there is a designated department that manages DRIP plans.
- Third-party-operated DRIP: As a way to cut costs and save time, some companies outsource their plans to a third party that handles the entirety of the plan.
- Broker-operated DRIP: Some companies may not offer a DRIP at all, but brokers may provide a DRIP on some investments to investors. With a broker-operated DRIP, brokers purchase shares on the open market. Brokers may or may not charge a small commission for DRIP stock purchases.
How do DRIPs work?
Typically, when you receive a dividend, it’s paid as a cash deposit into your brokerage account. With a DRIP, you receive more shares of the stock instead of cash.
DRIPs work by reinvesting a set amount of earned dividends on the date they are usually paid out. “You purchase additional fractional shares of the stock on the date the dividend is paid,” says Philip Weiss, financial advisor and founder at Apprise Wealth Management. “The term can apply to any automatic arrangement that allows you to reinvest the dividends you receive in an account held at a brokerage or investment company.”
This kind of plan implements an investment strategy known as dollar-cost averaging, which involves making investments of equal amounts, at regular intervals, regardless of how the stock market is performing. For investors who have a difficult time keeping their hands off their portfolio when the market is bumpy, DRIPs can not only help automate investing but can also help spread out some of the risk they assume by continuously investing no matter what the market is doing.
Pros and cons of DRIPs
Pros
- DRIPs are one way to automate your investing strategy. When you opt to have your dividends automatically reinvested, it’s one less financial to-do on your list. It also keeps you accountable to your long-term goals, even when the market is shaky and you may be tempted to react in the moment—a move that could potentially cost you more in the long-run.
- Shareholders can score a discount. DRIPs can help you cut costs. “Some companies allow you to purchase shares through a DRIP at a small discount [of] 1%–10%,” says Weiss.
- Can pause or adjust DRIP at any time: If you’re uncertain about using a DRIP, you can always try it out and change your mind later. You can pause your DRIP plan if you want the cash instead later. Some plans also let you choose to reinvest part or all of your dividend, so you can create your own Goldilocks-style plan.
- Compounding returns: As dividends increase over time, the number of shares you get through a DRIP can also increase (assuming the share price doesn’t increase by the same amount as the dividend). This amplifies the power of compounding returns.
Cons
- Shareholders could end up paying higher share prices. Because shares are automatically purchased, investors may end up investing at a time when prices are on the higher end.
- DRIP plans could throw your portfolio off balance. If you reinvest through a DRIP continually, you may accumulate a larger position in the company than intended. Overexposure to a particular company could increase your risk and hurt you in the long run if your portfolio doesn’t have a good mix of assets.
- DRIP may have a minimum: Some DRIPs may require a minimum, such as that you own at least five shares or reinvest at least 10% of your dividend.
- Still owe taxes on reinvested dividends: You’ll still need to pay taxes on the dividend as if you received cash, even if you reinvest it. More details on this below.
DRIP Example
To see a DRIP in action, consider the following example.
Assume you own 500 shares of Company A when it declares a $2 per share dividend. If you took the dividend as a cash payment, you’d receive $1,000 in cash. If, on the other hand, you reinvested that dividend when the stock is trading at $100 per share, you could instead receive 10 more shares of the company (the cash value of your dividend divided by the share price).
If Company A offered DRIP shares at a 10% discount, you could receive 11.11 shares ($1,000/$90 reduced share price).
Now your position in Company A is 611.11, so when the next dividend is paid, you receive an even larger amount and thus could receive even more shares. For example, if the next dividend is also $2 per share, you’d receive $1,222.22 worth of shares. At $90 per share with the discount, that’s an additional 13.58 shares. So, for the next dividend payment, you’ll have 624.69 shares.
As you continue to reinvest and increase your position over time, your dividends will continue to grow. This allows you to maximize the power of compounding to its fullest extent as each dividend reinvestment earns you even more dividend payments.
Of course, share prices are likely to fluctuate, so your DRIP may not reinvest at $90 per share each time. But even if the price rises, you’ll still be getting in at a discount, if your DRIP plan offers one. Similarly, it’s equally likely that the company may increase its dividend over time, so you could still come away with more shares at each reinvestment.
How DRIPs impact your taxes
DRIPs can be beneficial for investors in more ways than one. But there are still tax implications even if the funds go directly back into the company you’ve invested in.
“Under the tax rules, any time an investor has a choice between receiving a cash dividend or additional shares, the shareholder gets taxed on the cash value of the dividend,” says Weiss. “Reinvested dividends are taxed the same as cash dividends. But the amount of the dividend gets added to your basis in the shares. This means that you will have a smaller gain (or a larger loss if the investment works against you) if [or] when you sell the shares in the future.”
Your DRIP dividends will be reported on your 1099-DIV tax form each year. Alternatively, you can bypass this tax headache by holding DRIP stocks in a retirement account like an individual retirement account (IRA) where taxes aren’t due until withdrawal.
Are DRIPs a good investment?
DRIPs can be seen as both a good and not-so-good investment, depending on your perspective.
These plans are great ways to increase your investment over time without needing to add additional funds yourself. They let you take full advantage of the power of compound growth while taking the emotional turmoil of when to buy shares out of the equation. In some regards, this may be the easiest way to grow your investment over time.
However, now that many brokerage firms no longer charge trading commissions and may let you purchase fractional shares directly, the appeal of a DRIP isn’t quite as strong as before.
You could take a bit more active role in your reinvestment by letting the dividends come as cash payments and then placing your own trades for additional shares. This lets you control the share price you reinvest at and also opens the door for the temptation to time the market. If you aren’t diligent, you could end up with an accumulation of cash in your account instead of an accumulation of stock.
Creating your own manual reinvestment plan also means you won’t get a discount on the shares. So, if your DRIP offers a discount on the reinvestment price, it may be worth taking advantage of it.
A final important consideration about DRIPs is that dividends are not guaranteed. A company can stop or decrease its dividend at any time. So, if you’re relying solely on your DRIP to increase your share amount, keep a close eye on the company’s dividend declarations in case they decide to press pause.
The takeaway
DRIPs can offer long-term investors a way to save money while increasing their position as they continue to invest in the same company over time. However, it’s important to weigh your long-term goals with your short-term needs to determine if participating in a DRIP makes sense for you.
If you need income now, it may be more beneficial to take the dividends as cash payments. This would allow you to use the additional funds to cover expenses rather than needing to sell shares to generate cash.
Similarly, if you already hold a significant position in the company, you may not want to continue reinvesting through a DRIP.
On the other hand, if you don’t need investment income and are willing to grow your position in the company, a DRIP is a great way to do so automatically and at a potentially lower per-share price.
