Are you new in the field of investing? You might be wondering what the meaning of dividend reinvestment plan is. Is it good for investors or is it bad?
Today we will discuss to you everything you need to know about dividend reinvestment plan and what are the advantages and disadvantages you should know about when investing in dividend reinvestment plan.
What is a Dividend Reinvestment Plan?
A dividend reinvestment plan or DRIP is offered by a corporation, which permits investors to reinvest their cash dividends into additional shares or fractional shares of the underlying stock on the dividend payment date.
Most of DRIPs permit investors to purchase shares commission-free and at a significant discount to the current share price. DRIPs do not allow reinvestments that are lower than $10.
Meanwhile, this term is also abbreviated sometimes as DRP.
DRIPs are also offered by various companies to give shareholders an option of reinvesting the amount of a declared dividend. When dividends are paid, the shareholders will receive them as a check or direct deposit in their back account.
Since shares bought through a DRIP typically come from the company’s own reserve, they are not marketable via stock exchanges.
Even though these dividends are not actually received by the shareholder, they still need to be reported as taxable income.
However, if a company does not offer a DRIP, you can set up one through a brokerage firm, as many brokers allow dividend payments to be reinvested in the shares of any stock held in an investment account.
But if a company is operating the drip, it would set a specific times in the year when the purchase of shares by shareholders in its DRIP program is allowed.
You should also know that a company does not go into the secondary market and buy the shares and sell them through the DRIPs. The shares that were sold through DRIP came from the share reserve of the company.
Meanwhile, if the DRIP is operated via a brokerage firm, it simply purchases shares for you from the secondary market. They will also add the shares to your brokerage account and these share will eventually sold back on the secondary market.
How to Start DRIP?
Starting a DRIP account requires some work from the investor. You have to look for the companies or brokerages that offer DRIPs. One great resource of finding these is the internet.
When you already found a company that offers DRIP, you must now know who runs the plan, is it the company or a transfer agent. After that, you have to purchase shares in the company to set up an account.
Meanwhile, in order to qualify for a DRIP, the shareholder is often required to have his or her name registered on the stock certificates.
Types of DRIP
Due to the growing popularity of DRIP, more companies are setting up DRIPs. However, it is better for you to know that not all plans are set up and run in the same manner.
Companies who operate DRIPs will have their investor relations department handle all aspects of the plan. They even sometimes allow individuals to purchase a share of the company directly from this department as opposed to from a broker.
Other companies find the costs too great and they use third parties, or transfer agents, who act on behalf of the company. These transfer agents also the one who hold the DRIP details of the company.
The other type of DRIP is set up through a brokerage. Since not all companies have dividend reinvestment plan, some brokerages will see this void and will allow investors to reinvest dividends at no costs, which stimulates a DRIP.
However, you should be aware that these brokerage-run plans only allow for the reinvestment of dividends and provide no cash purchase option.
You should also remember that brokerages are out to make a buck too, and will only offer this service for consumers who use their account to make commissioned trades.
Pros and Cons of DRIP
But before you enter dividend reinvestment plan, you should know what are the advantages and disadvantages that comes with DRIP.
Here some of the advantages that comes with dividend reinvestment plan.
One of the best things about dividend reinvestment plan is that it does not require any commission to be paid. Most of the online brokers do not charge any commission fees when an investor decided to reinvest their dividends back into shares of the stock.
This is good for investors as they can lessen the overall costs. Also for the brokers who gets to hang onto a client longer by offering this feature.
Purchase Fractional Shares
If you receive $20 from a dividend payment and the price of the share is $40, a DRIP can make it possible to purchase 5 shares.
This will allow you to continue build your position by reinvesting all of your dividend payment back into the stock. You can do this without waiting to purchase a full share.
Automated Stock Purchase
This type of plan can be set up to automatically reinvest any dividend payments straight back into the stock. This does not required any action by the investor, which makes it a good option for investors who are busy.
This feature only takes less than 5 minutes to set up with an online broker.
No Lower Limit
With DRIP there is no lower limit, whether if its offered by the company or a broker. You can own as little as one share, and you will still be eligible for the program. This actually gives all investors to be able to benefit from the program.
Company DRIP Discount
Some companies provide discount when investors purchase shares under their DRIP program. This means that investors can buy additional shares at a discount price every time they use their dividends.
However, most companies might not offer a significant discount to market price, with the discount ranging from 1 percent to 5 percent.
Meanwhile, DRIP might sound a little attractive, but it has some disadvantages you might want to know. Here are some of the cons you might encounter with DRIP.
When you utilize the DRIP program, dividends will continuously reinvest into the company that paid the dividend. This means that there are no new funds for investors to buy new companies and diversify his or her portfolio.
This actually might cause some companies to be over-weighted within the portfolio, amplifying the negative impact of a price decline in the specific company.
No Income Stream
This is one of the most let down with investing in DRIP, especially for retirees who are in the “distribution stage” of their lives. Although investing in DRIP allows you to increase the shares you have over time, the means that you sacrifice receiving your dividends.
Meanwhile, for retirees it depends on their dividends to sustain their day-to-day expenses, utilizing DRIP will not be feasible.
You have to keep records of your transactions if you invest with DRIPs outside of a tax advantaged retirement account. Making several stock purchases every year can give different cost basis for each stock you own.
Meanwhile, you can alleviate this hassle by investing in an IRA or any other tax advantaged account. You can also use a brokerage that provides tax management software.
Initiating New Positions
A lot of investors who uses the income they generated from dividends to initiate a new position in their portfolio.
However, using DRIP prevents this from happening. Since all of the income will be reinvested back into the same stocks. This also leaves no money to open positions in new stocks.
No Control on Valuation & Timing
When you purchase share, you take many factors into consideration. This includes the trend of the stock price and the assessment of the shares. Some investors may only be willing to purchase shares when they are below a certain price or when the trend of stock price is in their favor.
However, with DRIP you have no control over when you will buy shares because they are automatically bought when the dividend arrives.
Getting into dividend reinvestment plan is not that quite hard. As long as you know what you are entering.
You have to make sure that you have knowledge about it. You also have to look for companies or brokerages that offer DRIP.
Do your research first, learn what is DRIP all about. It will also be a good thing to know the advantages and disadvantages that comes with DRIP.
Know this is important since you might encounter some cons that may affect your investment. But once you know about these, you will know what to do with them in the future.
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