Stocks are a popular investment because they offer higher potential growth than savings accounts or bonds. Owning stock means you own a portion of a company. Companies make money and often pay some of their revenue out to shareholders in the form of dividends.
Dividends let investors turn their portfolio into a source of income they can use to cover living expenses, but not everyone wants to get cash out of their investments. Some would prefer to reinvest their profits to help their portfolio grow further. Dividend reinvestment plans (DRIPs) can help investors do that.
The theory behind dividend reinvestment plans is simple. Many companies reward shareholders with periodic cash payments to investors who own shares of their stock. Some companies give you the option of reinvesting those dividends to buy additional shares of the stock.
Even if a company doesn’t offer a DRIP program, your brokerage company may let you set up automatic reinvestment of dividends you receive, creating a DRIP for any stock and even for mutual funds that pay shareholders dividends.
Reasons to Invest in a Dividend Reinvestment Program
There are a number of reasons why investors take advantage of dividend reinvestment plans:
1. DRIPs Average the Cost of the Security in a Year
A common worry among investors is buying into shares at a high price, only to watch them drop. With a DRIP, you make small investments multiple times per year automatically. This can help smooth out the impact of price fluctuations as you buy shares at multiple prices over the course of the year.
2. You Can Receive Discounted Shares
Some DRIP programs offered directly by companies let investors purchase shares at a discount when they make those purchases with dividends. These discounts can also apply to stock purchases made with cash you had on hand rather than only applying to purchases using dividends.
This makes dividend reinvestment plans great tools for small investors who don’t make trades of large quantities of stock.
3. Potentially Faster Investment Growth
Compound interest is a powerful force. If you have $100 and earn 10%, after one year you’ll earn $10 in interest. After two years, you’ll have earned $21 in interest. After the third year, you’ll have earned $33.10 in total.
After 20 years you’ll have $672.75, of which $572.75 is interest.
A little bit extra means a lot when compounded over time. Cut the rate of returns in the example above from 10% to 7%, and you’ll end up with just $386.97 in your account, $286.97 of which is interest. Earning that extra 3% almost doubles your final results after compounding for 20 years.
Given that the dividend yield of the S&P 500 — an index of 500 of the largest companies in the United States — is 1.8% as of the time of writing, reinvesting the dividends can significantly increase your returns. Many companies offer even higher dividend yields, which means reinvesting dividends can further accelerate returns.
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Drawbacks of Dividend Reinvestment Programs
Before considering a DRIP, keep these drawbacks in mind.
1. Reduced Flexibility
If you use a DRIP, you automatically reinvest any dividends you earn in the same stock or mutual fund that paid those dividends. Over time, you may wind up buying more shares in investments that pay higher dividends, which can unbalance your portfolio.
Receiving those dividends as cash gives you the chance to choose different investments to buy with your proceeds on your own. This gives you more flexibility to choose new securities or asset classes to buy and helps to make sure your portfolio is properly balanced.
2. Tax Tracking
When you buy investments, you have to keep track of your cost basis for the investment for capital gains tax purposes. Your cost basis is the amount that you paid for the security. Each time you get a dividend and reinvest it in the company, you’re buying additional shares — or fractional shares — at a new price, and you need to track the cost basis of those shares.
If you invest in a DRIP for a company that pays quarterly dividends, you’ll be purchasing new shares at least four times per year. After a few years, you’ll own shares with a dozen different cost bases. When you eventually sell these shares it can be hard to track which shares you’re selling to determine the taxes you owe.
3. Dividend Taxes
On top of complicating capital gains taxes and cost basis tracking, dividends have immediate tax implications. Dividends count as income so you have to report any dividends you receive on your income tax return.
If you receive dividends as cash, you can use some of the money to pay those taxes and invest the rest. With a DRIP, the full amount of the dividend goes into purchasing additional shares, leaving you to pay the taxes another way.
How to Get Started
If you want to invest using a DRIP, here are some tips.
To get started with a DRIP, you’ll first need to determine whether the company you want to invest in offers a DRIP option for its shareholders. Many companies that pay dividends will also offer to reinvest them in a DRIP for you.
If you already own shares of stock in the company, you will usually need to contact the company and ask for an enrollment form. Sometimes this form will be available on the company’s website. If you purchased your shares through a broker, the broker’s name may be on the shares, so you’ll need to ask them to transfer the shares into your name.
When researching a DRIP, you’ll also want to make sure that there are no fees associated with its management. Although most companies won’t charge a fee, some do, and while the fees are usually small, they can be a serious drag on your profits if you only have a few shares and thus aren’t getting a lot in dividends.
The other option is to work directly with your brokerage instead to set up a DRIP. Many brokerages will let you automatically reinvest dividends that you receive. This lets you create DRIPs for companies that don’t offer them or for mutual funds that periodically pay out cash dividends.
If your brokerage doesn’t charge commissions, this can help you avoid fees the company issuing the shares charges for its DRIP. However, it also means missing out on potential benefits such as discounted shares.
Reinvesting Dividends and Taxes
Once you own the stock and have elected to reinvest your dividends, your dividends will continue to be reinvested until you tell the company or your brokerage otherwise, the company discontinues the reinvestment program, or the investment stops paying a dividend.
Each year, if your dividends totaled more than $10, you’ll receive a 1099-DIV form with the total income you earned. Even though you didn’t actually receive the dividend as cash, you may still end up paying taxes on the amount.
DRIPs Make Great Gifts
Shares set up in a DRIP make a great gift to help get kids interested in the stock market and finance. Consider this idea:
Many popular brands like Coca-Cola, Disney, and McDonalds pay regular dividends. A child or teenager may not appreciate finance, but they’re probably familiar with and like certain brands or products. If you tell a child that they can own a share in one of their favorite brands, it may help get them more interested in investing.
Buy a share in the child’s favorite company and show them the dividend check or electronic deposit when it comes in. If you want, you can make it more real by giving them the amount of the dividend in cash, even as you reinvest the dividend for them.
Each quarter, the dividend will grow as the number of shares they own increases. This lets the child see the power of compounding. By the time they become an adult, they’ll have a small holding in a major company and a better appreciation for the power of reinvested dividends.
Pro tip: Before you add any stocks to your portfolio, make sure you’re choosing the best possible companies. Stock screeners like Trade Ideas can help you narrow down the choices to companies that meet your individual requirements. Learn more about our favorite stock screeners.
Anyone can get started with a dividend reinvestment program, but it will take a little time and effort. Once you’ve decided what company you’ll invest with, make sure they offer a DRIP and don’t charge fees. You may also need to transfer the stock certificate into your own name, or use a direct purchase plan to get shares in your preferred company.
Then, you’ll be on your way to saving lots of money and watching your investments grow hassle-free with a dividend reinvestment program.