For many income investors, the purpose of owning dividend stocks is to collect a steady stream of income. And many dividend paying stocks have done that job quite well. In the ultra-low-interest-rate environment over the past several years, dividend stocks have helped investors boost the yield of their income portfolios. However, if you don’t need to use the cash dividends immediately, you don’t have to collect them. This is because some dividend-paying companies offer investors the option of enrolling in a dividend reinvestment plan, or DRIP.
In this article, we are going to take a look at what a DRIP is, its pros and cons, how to enroll in a DRIP, and some of the most frequently asked questions about reinvesting dividends.
So, what is a dividend reinvestment plan?
Well, a dividend reinvestment plan is a plan offered by a dividend-paying company that allows investors to reinvest their cash dividends by purchasing additional shares of the company.
How do dividend reinvestment plans work?
Normally, when companies distribute dividends to investors, they either mail out a dividend check or directly deposit the money into their bank accounts. When an investor enrolls in a DRIP offered by a dividend paying company, they no longer receive the dividends in cash. Instead, their dividends will automatically be used to buy additional shares usually on the dividend payment date.
In a world where brokerage firms can make tons of money, one of the most obvious benefits of enrolling in a dividend reinvestment plan is the saving of commissions. As many investors know, every time you buy shares of a company from a brokerage, you need to pay a commission. If you were to reinvest dividends yourself, the money spent on commissions can quickly add up.
For instance, let’s say an investor owns 10 dividend stocks that each distribute on a quarterly basis and they want to reinvest all the dividends. If they were to reinvest those dividends themselves, they would need to buy new shares each time a company pays dividends. With 10 companies each paying dividends four times a year, that’s 40 new trades the investor needs to do through their brokerage. If the brokerage charges $10.00 for each trade they make, the investor would end up paying $400.00 a year just on commissions. For a long-term investor, that cost can quickly add up to thousands of dollars.
DRIPs, on the other hand, offers a much more cost-efficient way to reinvesting dividends. When a company offers a dividend reinvestment plan, shares purchased through the plan normally come from the company’s own reserves. Because an investor enrolled in the company’s DRIP is buying shares directly from the company rather than through a brokerage, they don’t need to pay commissions to the brokerage (Some companies use transfer agents to take care of their DRIPS; they usually cover the costs associated with the plan). At the same time, some companies allow existing shareholders enrolled in DRIPs to buy additional shares at a discount, which usually ranges between one percent and 10%.
Some companies may charge a small fee for investors to enroll in their dividend reinvestment plans. But with the savings on commissions and the possibility of buying shares at discount, the benefits of using DRIPs often outweigh the small enrollment fee.
On a side note, enrolling in DRIPs also saves the investor the time and effort to buy the shares themselves. It might not seem like a big hassle, but using the example above, the investor with 10 stocks paying quarterly dividends would have to put in 40 new trades every year to reinvest all the quarterly dividends by themselves. And because companies distribute on different dates each quarter, the investor would also need to keep track of all 40 dividend payment dates. Enrolling in DRIPs (if those stocks offer them) would automate the dividend reinvesting process.
Albert Einstein is said to have called compound interest, “the most powerful force in the universe.”
The power of interest compounding is a well-known concept to income investors. It is one of the most important reasons why people should start saving early. For dividend investors, it’s all about DRIPs investment. Dividend compounding can be just as powerful as interest compounding. This is because when an investor reinvests their dividend, it increases the number of shares they own and the next dividend payment will be bigger because of the larger share count. The compounding effect of reinvesting dividends is great for building up wealth over time.
Last but certainly not least, enrolling in DRIPs also allows investors to achieve dollar cost averaging. To put it simply, dollar cost averaging means investing a fixed amount of money at consistent frequencies over long periods of time—very similar to what a DRIP does. This will automatically lead to buying more shares when the price is low and fewer shares when the price is high. By doing so, an investor lowers the average cost of shares over time, increasing the opportunity to make a profit.
Of course, nothing is perfect. Despite all the advantages offered by DRIPs, they do come at a cost. The most obvious one is that if you choose to enroll in a DRIP, you won’t receive the dividend payments in your bank account. While DRIPs are great for building wealth over time, they are not for everyone. If you need your portfolio to provide you with a steady stream of income to cover everyday expenses, then collecting cash dividends as they are distributed would be a better choice.
Investment decisions are typically based on multiple factors. By automating the dividend reinvesting process, DRIPs don’t offer investors much control over the investment decision. The timing is set by the company, the price of shares are determined, and a DRIP only purchases shares of the company offering the DRIP. If, for instance, you find company A attractive and want to use dividends from company B to buy shares of company A, a DRIP would not allow you to do that.
The first thing to note is that in order to enroll in a dividend reinvestment plan of any company, you need to own shares of that company.
Since you are reading this article, you most likely have access to the Internet. So all you have to do is going to the company’s investor relations web site. On the web site, you’ll find information relevant to shareholders, such as dividend dates, earnings reports, and how to enroll in their DRIPs (if they offer one).
Let’s take 3M Co (NYSE:MMM) stock as an example. If you go to 3M’s investor relations web site, you’ll find a specific page about its dividend. On the dividend page, there is a document that explains the company’s dividend reinvestment plan. (Source: “Dividends,” 3M Co, last accessed February 14, 2017.)
According to the document, 3M’s DRIP is administered by Wells Fargo Shareholder Services. As long as an investor is a registered owner of 3M common stock, all they need to do to enroll in 3M’s DRIP is to go online or complete and sign the authorization card and mail it to Wells Fargo. 3M pays for the service fees and commissions related to dividend reinvestments, so every penny of a DRIP investor’s dividend goes to buying full and fractional shares of 3M stock.
One question that many investors have when they first found out about DRIPs is, “are dividends that are reinvested taxable?”
Well, the answer is “yes.” Dividends, even when reinvested through dividend reinvestment plans, are still taxable. This is because after an investor enrolls in a DRIP, although they don’t get to see cash dividends on their bank accounts, there are in fact cash dividends being paid. The investor merely chooses to reinvest them rather than collecting them. Therefore, even when an investor reinvests all the dividends they received using DRIPs, those dividends still count as income for the investor. The investor needs to include dividends from dividend reinvestment plans on their tax return.
What about the shares that are purchased through a DRIP?
Just like any stock, capital gains from shares bought under a dividend reinvestment plan are not calculated and taxed until the stock is sold by the investor.
Not all companies offer DRIPs to their shareholders. However, if an investor wants to reinvest dividends from a particular company that doesn’t offer a DRIP, may it be a dividend growth stock or monthly dividend stock, there is still a way to do it.
The method here is to set up a dividend reinvestment plan through a brokerage. Knowing that some companies don’t offer DRIPs, many brokerages allow investors to reinvest dividends at no or little cost. For investors that are already using brokerages to buy shares, it’s worthwhile to explore this option.
As is the case with almost any investment decision, the answer to whether an investor should enroll in a DRIP or take cash dividends depends on their own circumstances. If an investor wants to use the money to pay their bills, then collecting cash dividends would be most optimal. On the other hand, if an investor doesn’t need the cash at the moment but wants to gradually increase their ownership of the company, enrolling in a dividend reinvestment plan would provide a cost-efficient way of achieving that.