Dividend Reinvestment Plans, or DRIPs, are programs that automatically invest cash from dividends into additional shares of the stock making those dividend payments.
Stock investors can enroll in DRIP programs as a way to take advantage of compounding returns, dollar-cost averaging, and potential discounts on shares purchases.
Investors can sign up for DRIP programs through the public companies themselves, an online brokerage, or take on a do-it-yourself approach and reinvest stock dividends themselves. It’s not complicated, but to be an effective DRIP investor, you want to understand the ins and outs of this strategy.
Using Dividends to Buy More Shares of Stock
Dividends are distributed payments of corporate profits to shareholders. Companies can reinvest profits into their businesses or distribute them among shareholders. When they do the latter, those payments are called dividends.
The majority of dividends are paid quarterly, so four times a year. But some stocks or exchange-traded funds (ETFs) pay dividends monthly or annually.
Some companies don’t make enough money to cover their expenses and pay shareholders dividends. Most companies that pay dividends tend to be larger and have stable, reliable businesses.
Some of the most popular and effective DRIP stocks are offered by the so-called Dividend Aristocrats: These are companies that have increased their dividend payouts every year for at least 25 years.
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What Are DRIPs?
When an investor buys shares in a company that pays dividends, those dividends normally get paid out as a direct deposit or check. If investors sign up for a DRIP program, they have the option to reinvest the dividends back into their DRIP stocks rather than receiving the payout.
Thus, the reinvested dividends go towards additional shares of the same stock. When the dividend cash is reinvested, it can sometimes go into buying fractional shares — slices of whole shares. DRIP programs essentially use dollar-cost averaging, or the practice of making periodic purchases in order to mitigate the effect of stock volatility.
Investors must still report the dividends as taxable income even though they may not receive the dividends directly. Investors using a DRIP may want to consult a tax expert.
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Many times, additional shares in DRIPs are purchased directly from the company. Usually DRIP shares are issued directly from the company’s reserves and can’t be resold on a public stock exchange. Some brokerage accounts offer DRIP shares to investors — usually commission free or for a small fee.
How Does DRIP Investing Work?
As an example: Company X offers shareholders dividends of $1.76 per share each year, or $0.44 each quarter. Shareholders who take advantage of the DRIP can reinvest that money into more Company X shares.
If a shareholder owns 100 shares of Company X, they receive $44 in dividends every quarter. If Company X’s stock price is $88, the dividend reinvestment will buy the investor half of one share of stock.
For investors, participating in company DRIPs can be advantageous, especially when companies offer shares at a discounted rate. Some companies hire outside firms or transfer agents to run their DRIP.
Companies that offer DRIP shares can use the money from shareholders into growing their business. Also, DRIP shares are less liquid than regular shares since they can’t be sold on a public stock exchange. This means investors are more likely to hold onto the shares.
Shareholders in DRIPs tend to be stable, long-term stock holders, since they are using the program to grow their portfolio and have chosen to enroll in the plan with that particular company.
Online Brokerages and DRIPs
Online brokerages DRIPs can be easier for investors looking to invest in multiple stocks. Shareholders can choose to enroll in DRIPs for all of their investments or just for select companies.
That said, one disadvantage may be that brokerages don’t offer shares at a discounted level as company DRIPs do.
What Are Fractional Shares?
Some of the key advantages of traditional DRIP programs used to be zero-commission stock purchases and the ability to buy fractional shares. (Instead of purchasing one share of stock at its current value, it’s possible to purchase a fraction of one share of a stock, using whatever dollar amount they have available.)
But these days, many brokerages offer zero-commission trading and the ability to purchase fractional shares via a DRIP.
Pros and Cons of DRIPs for Investors
There are a number of reasons investors choose to reinvest their dividends through a Dividend Reinvestment Plan, and several reasons companies choose to offer them.
• Discounted Price: Discounts on DRIP shares can be anywhere from 1% to 10%. Investors can also purchase fractional shares through DRIPs, as noted above. This is useful because dividend payments may not be enough to buy an entire share of the stock.
• Dollar-cost Averaging: Because a DRIP reinvests dividends at steady intervals throughout the year, usually every quarter, these programs essentially provide a type of dollar-cost averaging, which helps to mitigate price volatility.
• Zero Commission: DRIP programs can allow you to buy new shares without paying commission fees. (However, many brokerages offer zero-commission trading outside of DRIPs these days.)
• Compounding Returns: If an investor buys an asset which pays out interest or dividends, and then they reinvest those earnings into buying more of the asset, they are then earning on both their initial investment and on the interest.
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• Automated Purchases: Investors can set up automatic reinvestment of their dividends into DRIP shares so they don’t even have to think about it after the initial set up.
• Less Liquid: DRIP shares aren’t as liquid as normal shares and can often only be sold back to the company directly. This means it will be difficult for an investor to quickly sell off shares.
• Require Monitoring: If an investor sets up automated DRIP investing, it can be easy to forget about the investment. Although the DRIP investment may be attractive at first, over time the market can change and the investor may want to allocate their money elsewhere, rebalance, or further diversify their portfolio.
• Limited Diversification: Investors sometimes use dividend income to invest in new stocks, but with DRIP investments they must invest the money back into more of the same stock. This may prevent portfolio diversification.
• Tax Reporting: Dividends are considered taxable income by the IRS, so even if you reinvest your dividends directly, they’re still reported to the IRS as income. That’s why figuring out tax reporting can be complicated with DRIPs. Investing in an IRA or using a brokerage account can help keep track of DRIP transactions. Again, consult a tax professional.
How to Set Up a DRIP
Whether your brokerage offers a DRIP or you have to sign up using a third-party manager (usually called a transfer agent), establishing a DRIP isn’t hard. It’s not like you have to select a range of investments options for reinvesting your dividends; they simply go toward purchasing more of the same stock.
That said, some DRIP plans charge fees for setting up the program. So you may want to check out the terms.
In order to start reinvesting via dividend reinvestment programs (DRIPs), investors must first own shares of stock in companies that offer dividend reinvestment. The share or shares must be owned in the investor’s name, not a broker’s name.
Dividends are steady payouts to company shareholders. By reinvesting these payouts every quarter, for example, the investor can buy more shares of that stock (or partial shares, a.k.a. fractional shares).
Investors need to remember that shares purchased via a DRIP may be cheaper, but they are less liquid because you can’t turn around and trade your DRIP stocks on a public exchange. Typically you have to sell them back to the company to redeem these shares. Also, dividends count as taxable income, even if they’re reinvested automatically through a DRIP, so consult a tax professional as needed.
Since there are hundreds of companies to choose from, it can be challenging to figure out which DRIP is the best. SoFi Invest® offers a full suite of tools and an easy to use mobile app for online investing. When you open an Active Invest account with SoFi, you can buy company stocks, ETFs, and fractional shares, while electing to participate in available DRIP programs.
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