Dividend Reinvestment Plans: How DRIP Investing Works

A dividend reinvestment plan, or DRIP, allows investors to reinvest the cash dividends they receive from their stocks into more shares of that stock. Hundreds of companies, funds, and brokerages offer DRIPs to shareholders. Reinvesting dividends through a DRIP may come with a discount on share prices or no commissions.

Of course, it’s possible to simply keep the cash dividends to spend or save, or use them to buy shares of a different stock. If you’re wondering, should I reinvest dividends?, it helps to know the pros and cons of dividend reinvestment programs and how they work.

What Is Dividend Reinvestment?

Dividend reinvestment typically means using the dividends you receive to purchase additional shares of stock in the same company rather than taking the dividend as a payout.

When you initially buy a share of dividend-paying stock, you typically have the option of choosing whether you’ll want to reinvest your dividends automatically.

Need a refresher on dividends? Check out what a dividend is and how they work.

What Is a Dividend Reinvestment Plan?

Depending on which stocks you invest in, you may have the option to enroll in a Dividend Reinvestment Plan or DRIP. This type of plan, offered by about 650 companies and 500 closed-end funds, allows you to automatically reinvest dividends as they’re paid out into additional shares of stock.

💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.

Types of Dividend Reinvestment Plans

There are two main types of dividend reinvestment plans. They are:

Company DRIPs

With this type of plan, the company operates its own DRIP as a program that’s offered to shareholders. Investors who choose to participate simply purchase the shares directly from the company, and DRIP shares are often offered to them at a discounted price. Some companies allow investors to do full or partial reinvestment, or to purchase fractional shares.

DRIPs through a brokerage

Many brokerages also provide dividend reinvestment as well. Investors can set up their brokerage account to automatically reinvest in shares they own that pay dividends.

DRIP Example

Here’s a dividend reinvestment example that illustrates how a company-operated DRIP works. If you own 20 shares of a stock that has a current trading value of $100 per share, and the company announces that it will pay $10 in dividends per share of stock, then the company would pay you $200 in dividends that year.

If you choose to reinvest the dividends, you would own 22 shares of that stock ($200 in dividends/$100 of current trading value = 2 new shares of stock added to your original 20). If the stock price was $200, you’d be able to purchase a single share; if it was $50, you could theoretically reinvest and own an additional four shares.

If, instead, you want cash, then you’d receive $200 to spend or save, and you’d still have the initial 20 shares of the stock.

Pros and Cons of DRIPs

If you’re wondering, should I reinvest dividends?, it’s a good idea to weigh the advantages and disadvantages of DRIPs. But note, too, that some of the pros and cons may be specific to one of the two types of DRIPs: Those offered through a company, and those through a brokerage.

Pros of Dividend Reinvestment Plans

On the “pros” side, one reason to reinvest your dividends is that it may help to position you for potentially greater long-term returns, thanks to the power of compounding returns, which may hold true whether investing through a company-operated DRIP, or one through a brokerage.

Generally, if a company pays out the same level of dividends each year — whether that’s 2%, 3%, or another amount — and you take your dividends in cash, then you’ll keep getting the same amount in dividends each year (assuming you don’t buy any additional shares).

But if you take your dividends and reinvest them through a DRIP, then you’ll have more shares of stock next year, and then more the year after that — which means, ideally, that the dollar amount of the dividends (at least in our example where the payout percentage is the same each year) will keep rising. Over a period of time, the amount you would receive during subsequent payouts could increase.

An important caveat, however: Real-life situations aren’t often as straightforward as this example, of course. For one thing, stock prices aren’t likely to stay exactly the same for an extended period of time.

Plus, there’s no guarantee that dividends will be paid out each period; and even if they are, there is no way to know for sure how much they’ll be. The performance of the company and the general economy can have a significant impact on company profitability and, therefore, typically affect dividends given to shareholders.

There are more benefits associated with DRIPs:

•   You may get a discount: Discounts on DRIP shares can be anywhere from 1% to 10%, depending on the type of DRIP (company-operated) and the specific company.

•   Zero commission: Most company-operated DRIP programs may allow you to buy new shares without paying commission fees. However, many brokerages offer zero-commission trading outside of DRIPs these days, too.

•   Fractional shares: DRIPs may allow you to reinvest into fractional shares, rather than whole shares that may be at a pricier level than you wish to purchase. This may be an option with either a company-operated or brokerage-operated DRIP.

•   Dollar-cost averaging: This is a common strategy investors use to manage price volatility. You invest the same amount of money on a regular basis (every week, month, quarter) no matter what the price of the asset is.

Cons of Dividend Reinvestment Plans

Dividend reinvestment plans also come with some potential negatives.

•   The cash is tied up. First, reinvesting dividends obviously puts that money out of reach if you need it, which may be particularly true for company-operated DRIP plans. That can be a downside if you want or need the money for, say, home improvements, a tuition bill, or an upcoming vacation.

•   Risk exposure. You should also keep potential risk factors in mind. For example, you may have concerns about the stock market in general, or about the particular company where you’re a shareholder, and reinvesting your cash into more equities may seem unwise.

Or you may need to rebalance your portfolio. If you’ve been reinvesting your dividends, and the stock portion of your portfolio has grown, using a DRIP could inadvertently put your allocation further out of whack.

•   Flexibility concerns. Another possible drawback to consider is that when your dividends are automatically reinvested through a DRIP, they will go right back into the company that issued the dividend. Though some company-operated DRIPs do give investors options (such as full or partial reinvestment), some investors may find that those DRIPs offer limited options as to where to reinvest their funds.

Perhaps you’d simply rather buy stock from another company – an option which may be available through a brokerage-operated DRIP. Note, though, that even brokerage-operated DRIPs may reinvest dividends as soon as they’re paid, so investors may not have a chance to redirect the investment.

•   Less liquidity. Also, when you use a company-operated DRIP, and later wish to sell those shares, you must sell them back to the company in many cases. DRIP shares cannot be sold on exchanges. Again, this will depend on the specific company and DRIP, but is something investors should keep in mind.

💡 Quick Tip: How to manage potential risk factors in a self-directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

Cash vs Reinvested Dividends

Should I reinvest dividends or take cash instead? How you approach this question can depend on several things, including:

•   Your short-term financial goals

•   Long-term financial goals

•   Income needs

Accepting the cash value of your dividends can provide you with ongoing income. That may be important to you if you’re looking for a way to supplement your paychecks during your working years, or for other income sources if you’re already retired.

As mentioned earlier, you could use that cash income to further a number of financial goals. For instance, you might use cash dividend payouts to pay off debt, fund home improvements or put your kids through college. Or you may use it to help pay for long-term care during your later years.

You might consider a cash option for dividends rather than reinvesting dividends if you’re already building sufficient wealth for retirement in your portfolio. That way, you can free up the cash now to enjoy it or address other current priorities.

Cash may also be more attractive if you’re comfortable with your current portfolio configuration and don’t want to purchase additional shares of the dividend stocks you already own.

On the other hand, reinvesting dividends automatically through a DRIP could help you to increase your savings for retirement. This assumes, of course, that your investments perform well and that the stocks you own don’t decrease or eliminate their dividend payout over time.

Tax Consequences of Dividends

For those wondering, do you have to pay taxes on reinvested dividends?, one thing to keep in mind is that dividends — whether you cash them out or reinvest them — are not free money. There may be tax consequences when you receive dividends because if the amount is significant enough, you might need to pay income taxes on what you’ve earned.

Each year, you’ll receive a tax form called a 1099-DIV for each investment that paid you dividends, and these forms will help you to determine how much you owe in taxes on those earnings.

Dividends are considered taxable whether you take them in cash or reinvest them — even though when you reinvest, the money isn’t currently available for you to spend.

The exception to that rule is for funds invested in retirement accounts, such as an online IRA, as the money invested in these accounts is tax-deferred. If you have received or believe you may receive dividends this year, it can make sense to get professional tax advice to see how you can minimize your tax liability.

Should You Reinvest Dividends?

Reinvesting dividends through a dividend reinvestment plan is partly a short-term decision, and mostly a long-term one.

If you need the cash from the dividend payouts in the near term, or have doubts about the market or the company you’d be reinvesting in (or you’d rather purchase another stock), you may not want to use a DRIP.

If on the other hand you don’t have an immediate need for the cash, and you can see the value of compounding the growth of your shares in the company over the long haul, reinvesting dividends could make sense.

The Takeaway

Reinvesting dividends and using a dividend reinvestment plan (DRIP) is an automatic feature investors can use to take their dividend payouts and use them to purchase more shares of the company’s stock. However, it’s important to consider all the scenarios before you decide to surrender your cash dividends to an automatic reinvestment plan.

While there is the potential for compound growth, and using a DRIP may allow you to purchase shares at a discount and with no transaction fees, these dividend reinvestment plans are limiting. You are locked into that company’s stock during a certain market period, and even if you decided to sell, you wouldn’t be able to sell DRIP shares on any exchange but back to the company. Whether you use a DRIP or not, you may want to consider having some dividend-paying stocks as part of a balanced portfolio in your investment account.

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FAQ

How do you set up a dividend reinvestment plan?

There are two ways to set up a dividend reinvestment plan. First, you can set up an automatic dividend reinvestment plan with the company whose stock you own. Or you can set up automatic dividend reinvestment through a brokerage. Either way, all dividends paid for the stock will automatically be reinvested into more shares of stock.

Can you calculate dividend reinvestment rates?

There is a very complicated formula you can use to calculate dividend reinvestment rates, but it’s typically much easier to use an online dividend reinvestment calculator instead.

What is the difference between a stock dividend and a dividend reinvestment plan?

A stock dividend is a payment made from a company to its shareholders (people who own shares of their company’s stock). A dividend reinvestment plan allows investors to reinvest the cash dividends they receive from their stocks into more shares of that stock.

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