When investors hold dividend-paying securities, they may want to consider using a dividend reinvestment plan, or DRIP, which automatically reinvests cash dividends into additional shares, or fractional shares, of the same security.
Using a dividend reinvestment strategy can help acquire more dividend-paying shares, which can add to potential compound gains. But companies are not obligated to keep paying dividends, so there are risks.
It’s also possible to keep the cash dividends to spend or save, or use them to buy shares of a different stock. If you’re wondering whether to use a dividend reinvestment program, it helps to know the pros and cons.
Key Points
• Dividend reinvestment plans (DRIPs) allow investors to reinvest cash dividends into more shares of the same securities.
• DRIPs can be offered by companies or through brokerages, with potential discounts on share prices, or no commissions.
• There are two types of DRIPs: company-operated DRIPs and DRIPs through brokerages.
• Reinvesting dividends through a DRIP may lead to greater long-term returns due to compounding.
• However, DRIPs have limitations, such as tying up cash, risk exposure, and limited flexibility in choosing where to reinvest funds.
What Is Dividend Reinvestment?
Dividend reinvestment plans typically use the cash 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, or shares of a mutual fund that pays dividends, you typically have the option of choosing whether you’d want to reinvest your dividends automatically to buy stocks or more shares, or take them as cash.
Numerous companies, funds, and brokerages offer DRIPs to shareholders. And reinvesting dividends through a DRIP may come with a discount on share prices, for example, or no commissions.
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What Is a Dividend Reinvestment Plan?
Depending on which securities you invest in, you may have the option to enroll in a Dividend Reinvestment Plan or DRIP. This type of plan, offered by numerous companies and brokerages, allows you to automatically reinvest dividends as they’re paid out into additional shares of stock.
Note that some brokerages offer what’s called synthetic DRIPs: meaning, even if the company itself doesn’t offer a dividend reinvestment program, the brokerage may enable you to reinvest dividends automatically in the same company stock.
How DRIPs Help Build Wealth Over Time
Reinvesting dividends can, in some cases, help build wealth over time.
• The shares purchased using the DRIP plan are bought without a commission, and sometimes at a slight discount to the market price per share, which can lower the cost basis and potentially add to gains.
• Using a dividend reinvestment plan effectively offers a type of compounding, because buying new shares will provide more dividends as well, which can again be reinvested.
That said, shares bought through a DRIP plan cannot be traded like other shares in the market; they must be sold back to the company.
In that sense, investors should bear in mind that participating in a dividend reinvestment plan also benefits the company, by providing it with additional capital. If your current investment in the company is aligned with your financial goals, there may be no reason to reinvest dividends in additional shares, and risk being overweight in a certain company or sector.
💡 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 can be 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.
Partial DRIPs
In some cases a company or brokerage may allow investors to reinvest some of their dividends and take some in cash to be used for other purposes. This might be called a partial DRIP plan.
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). These new shares would also pay dividends.
If, instead, you wanted cash, then you’d receive $200 to spend or save, and you’d still have the initial 20 shares of the stock.
If you wanted to reinvest part of your dividends through the DRIP plan, you might be able to purchase one share of stock for $100, and take $100 in cash. Again, not all companies offer flexible options like this, so it’s best to check.
Long-Term Compounding With DRIPs
Again, reinvesting dividends in additional company shares can create a compounding effect: The investor acquires more shares that also pay dividends, which can then be taken as cash or reinvested once again in more shares of the same company.
That said, there are no guarantees, as companies are not required to pay dividends. In times of economic distress, some companies suspend dividend payouts.
In addition, if the value of the stock declines, or it no longer makes sense to keep this position in your portfolio, long-term compounding may seem less appealing.
Pros and Cons of DRIPs
If you’re wondering whether to reinvest your dividends, it’s a good idea to weigh the advantages and disadvantages of DRIPs.
Pros of Dividend Reinvestment Plans
One reason to reinvest your dividends is that it may help to position you for higher 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 the same dividend amount each year 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. Over a period of time, the dividend amount you might receive during subsequent payouts could also increase.
An important caveat, however: 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 and purchase 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: Dollar-cost averaging is a strategy investors use to help manage price volatility, and lower their cost basis. 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 puts that money out of reach if you need it. 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. There are a few potential risk factors of reinvesting dividends, including being overweight in a certain sector, or locking up cash in a company that may underperform.
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, and you may need to rebalance your portfolio.
• Flexibility concerns. Another possible drawback to consider is that when your dividends are automatically reinvested through a DRIP, they will go right back into shares of stock in the company or fund that issued the dividend.
Though some company-operated DRIPs do give investors options (such as full or partial reinvestment), that’s not always the case.
• Less liquidity. When you use a company-operated DRIP, and later wish to sell those shares, you must sell them back to the company or fund, 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
Taking dividends in cash 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.
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 shares you own don’t decrease or eliminate their dividend payout over time.
Tax Consequences of Dividends
One thing to keep in mind is that dividends — whether you cash them out or reinvest them — are not free money. Dividend income is taxed in the year they’re paid to you (unless the dividend-paying investment is held in a tax-deferred account such as an IRA or 401(k) retirement account).
• Qualified dividends are taxed at the more favorable capital gains rate.
• Non-qualified, or ordinary dividends are taxed as income.
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 through a DRIP. The value of the reinvestment is considered taxable.
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.
How DRIPs Affect Cost Basis
When dividends are reinvested to buy more shares of the same security, the DRIP creates a new tax lot. This can make calculating the total cost basis of your share holding more complicated. It may be worth considering working with a professional in that case, to ensure that you end up paying the right amount of tax when you sell shares.
The complexity around calculating the cost basis is another reason some investors reinvest dividends within tax-deferred accounts. In this case, the overall cost basis doesn’t matter, as withdrawals from a tax-deferred account — such as a traditional IRA or 401(k) — would be simply taxed as income.
Should You Reinvest Dividends?
Reinvesting dividends through a dividend reinvestment plan is partly a short-term decision, and mostly a long-term one.
Factors to Consider Before Reinvesting
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 investment), 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.
If taxes are a concern, it might be wise to consider the location of your dividend-paying shares.
The Takeaway
Using a dividend reinvestment plan (DRIP) is a strategy investors can use to take their dividend payouts and 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.
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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 or fund whose shares 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 the same 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’s 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.
Are dividend reinvestments taxed?
Yes, dividend reinvestments are taxed as income in the case of ordinary dividends. Qualified dividends are taxed at the more favorable capital gains rate. Dividends are subject to tax, even when you don’t take the cash but reinvest the payout in an equivalent amount of stock.
What are the benefits of using DRIPs for long-term investing?
One potential benefit of using a DRIP long term is that there may be a compounding effect over time, because you’re buying more shares, which also pay dividends, which can also be reinvested in more shares. This strategy could prove risky, however, if the company suspends dividends or if you become overweight in that company or sector.
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