A dividend reinvestment plan is generally easy to set up, which makes them a popular feature for investors. DRIPs help investors automate their dividend reinvestment’s while lowering the costs of commissions and other fees. Basically, a lot of successful income investors use dividend reinvestment plans on at least a few stocks in their portfolio.
There are plenty of advantages to setting up dividend reinvestment plans, but there are also a few disadvantages to consider. This article will focus on what DRIP is, its types and some of its pros and cons.
What is a Dividend Reinvestment Plan (DRIP)?
A dividend reinvestment plan is a plan offered by a corporation that allows investors to reinvest their cash dividends. These cash dividends turn into additional shares or fractional shares of the underlying stock on the dividend payment date.
DRIPs are offered by many companies to give shareholders the option of reinvesting the amount of a declared dividend through additional shares.
Normally, when dividends are paid, shareholders receive them as a check or a direct deposit into their bank account. Because shares from DRIP typically come from the company’s own reserve. Also, they are not marketable through stocks exchanges as shares must be redeemed directly through the company.
Although these dividends are not actually received by the shareholder, they still need to be reported as taxable income. If a company doesn’t offer a DRIP, one can be set up through a brokerage firm, as many brokers allow dividend payments to be reinvested in the shares of any stock held in an investment account.
Types of Dividend Reinvestment Plans
There are a couple of different types of dividend reinvestment plans available. One allows the investor to purchase stock directly through the company, while the other requires a third party to invest.
There are several companies that actually run their own dividend reinvestment plans. These companies usually allow the investor to buy shares of their company directly through them without a broker.
They also allow investors to buy partial shares which is a great way to invest if you don’t have a lot of capital to start with. Popular companies like McDonald’s Corporation and Procter & Gamble are just a few of the many companies offering this service.
Most online discount brokerages allow their customers to reinvest their earned dividend back into the stock at no cost. The incentive for the broker is to keep it’s current clients by offering this feature.
Whereas, the investor gets a discount on the expenses they will have to pay. Setting up a DRIP through an online broker usually takes just a few minutes to complete. That makes it an easy to use investment tool.
If an investor receives $20 from a dividend payment and the share price of the stock is $40, a DRIP makes it possible to purchase .5 shares. This allows the investor to continue to build their position. This is through reinvesting all of their dividend payments immediately back into the stock without waiting to buy a full share.
Automatic Stock Purchase
These types of plans can be set up to automatically reinvest any dividend payments directly back into the stock. There is no action required by the investor making it a nice option for those of us with hectic lives. It generally takes less than 5 minutes to set up this feature with an online broker.
Free of Commission
A great thing about dividend reinvestment plans is that they generally don’t require any commission be paid. Most online brokers don’t charge any commission fees when an investor decides to reinvest their dividends.
This is great for the investor as they can lower the overall costs. This is also great for the broker who gets to hang onto a customer longer by offering this feature.
No Lower Limit
There is no limit for DRIP no matter whether it is offered by the company itself or the broker. Investors can own as little as one share, and still be eligible for the program.
This gives all investors, including those with relatively less money to invest in stocks to be able to benefit from the program all the same.
Company/Fund DRIP Discount
Some companies offer a discount when investors buy shares under their DRIP program. This simply means that investors can purchase additional shares at a discount to the market price every time.
Most companies might not offer a significant discount to market price, with the discount ranging from 1% to around 5%. Although this doesn’t sound like much, it does add up over time. That gives investors utilizing the DRIP program an advantage over their other counterparts.
Although DRIP investing sounds attractive. It’s patent that there are some cons of reinvesting dividends.
Diversification of Portfolio
Setting up a DRIP for the long term can prevent an investor from having a diversified portfolio. It’s crucial for the investor to monitor stocks in their portfolio to make sure any dividends should automatically be reinvested.
Many investors use the income they make from dividends to initiate a new position in their portfolio. Using a DRIP prevents this from happening as all the income is reinvested back into the same stocks. That leaves no money to open positions in new stocks.
Tax Tracking Fuss
You need to keep excellent records of your transactions if you invest with DRIPs outside of a tax advantaged retirement account. Making multiple stock purchases each year can give you a very different cost basis for each stocks you own. You can lessen this hassle by investing in an IRA or other tax advantaged account.
No Income Stream
This is a big con of DRIP investing, especially for retirees in the “distribution stage” of their lives. Although DRIP investing allows investors to increase their shares over time, this means that they sacrifice receiving their dividends.
For retirees depending on their dividends to sustain their day-to-day expenses, utilizing the DRIP program won’t be feasible. As for younger investors, it may also be a con for them since it eliminates this stream of passive income.
No Control on Valuation & Timing
When investors buy shares, they take many factors into consideration. This includes the trend of the stock price and the valuation of the shares. We may only be willing to buy shares when they are below a certain multiple of earnings. Or only when the stock price’s trend is in our favor.
When utilizing a DRIP program, we have absolutely no control over when we want to buy shares. That’s because shares are automatically purchased when the dividend arrives. Hence, we might purchase shares at valuations that are unacceptable to us.
Experienced and successful dividend investors certainly use dividend reinvestment plans to their advantage. In some cases, it’s indeed reasonable to set up one of these plans to build a position in a new dividend paying stock.
There are some times when setting up a DRIP just doesn’t add up. The main way for that is understanding when to use DRIPs and when to leave them alone and manage the dividends yourself.
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