Dividend Reinvestment Plan (DRIP) | Definition/ˈdivəˌdend rēinˈvestmənt plan/
automatically reinvests dividends earned from a company to earn more shares over time.
Next word Debt-to-Income (DTI) Ratio ᐳ
At one point or another, a person begins thinking about the future and how they wish to have money set aside for when they choose to retire. Thus, this decision leads to them opening a brokerage account and buying stocks in hopes of compound interest increasing their money in the long term.
Also, to reap the benefits of their investment before retirement, many turn to dividend stocks, which pay out cash dividends at the end of each fiscal quarter. Although these dividend stocks appeal to investors as they allow them to buy more shares, they are left in a dilemma; do they accept the dividend payments, do whatever they wish with the extra money, or enroll in a dividend reinvestment plan (DRIP)?
How does a dividend reinvestment plan work?
A dividend reinvestment plan automatically reinvests dividends. When a company pays out dividends when you enroll in a DRIP, the dividend payout is reinvested into the company to receive additional shares. Suppose the dividend amount does not amount to a full share. In that case, the dividend income will be set aside until the next dividend payout period. The remainder of the previous quarterly dividend will be combined with the current quarter’s dividend income to purchase shares.
Benefits of a Dividend Reinvestment Plan
A DRIP is a crucial investment tool that many use. However, before determining whether this feature is suitable for an investor’s needs, below are some benefits of enrolling in a DRIP.
Elimination of Transaction Fees
One of DRIP's main advantages is eliminating transaction fees associated with trading stocks. For example, when investing with a brokerage account, the intermediary puts a transaction fee on any trades made by the investor. However, a DRIP plan removes this transaction fee, meaning that the investor will over time receive more shares due to the money saved from not paying transaction fees.
Share Purchase Discount
Another incentive DRIPs provide to investors is a purchase discount. When investors enroll in a DRIP, they get offered a discount on shares they purchase from the company. Typically, the discount is between one and five percent; however, the minor discount could potentially incentivize investors to enroll in a DRIP to save money when investing in companies.
Over time, the money saved from the discounts can purchase additional shares and further increase the number of shares within an investor’s portfolio.
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Passive Investment Method
Not all investors have a significant amount of time researching multiple companies to invest in thoroughly. Instead, they typically choose to invest in companies that have historically done well. Due to this investment method, a DRIP would be beneficial to them as they would automate the service, meaning that any and all dividends received would be reinvested into the company.
As a result, the constant automation of share purchases minimizes the inflation an investor faces and maximizes the chances their money will rise due to compound interest in the future.
Alter Amount of Dividend Income Invested
Lastly, a DRIP allows the investor to determine the portion of the cash dividend he keeps and reinvests in the company. Some investors who are focused on long-term goals such as retirement will put a majority, if not all, of their dividend income towards purchasing more shares. However, on the other hand, investors who wish to use their dividend income elsewhere can allocate a smaller portion of the income towards purchasing more shares.
The flexibility of the DRIP allows more investors with different mindsets to utilize the same feature and tailor it to their needs.
Disadvantages of a Dividend Reinvestment Plan
As with any type of investment tool, there will always be disadvantages to be discussed. The DRIP is not a perfect investment method and has its fair share of cons; below are some negative factors that should be considered when utilizing this investment tool.
Lack of Diversification
When investing through a reinvestment program, many benefits stand out as to why it makes sense for them to begin reinvesting their dividends through a DRIP plan. However, one aspect which may get overlooked is the lack of diversification within their portfolio.
To mitigate the risks of investing in the stock market, many begin putting their money in different industries to maximize their returns while minimizing their risk. However, a DRIP plan allows the investor to only invest in the company that issued the dividends. Therefore, although the investor is maximizing the number of shares they can buy, they are also taking on a more considerable amount of risk due to the growing portion of their portfolio associated with the dividend-paying company.
Consequently, if the company begins to perform poorly, a minor dip in the stock price can have a major impact on the investor’s portfolio due to their large holding. As a result, it is essential to invest in other sectors to mitigate the increased risk of reinvesting in dividend-paying companies.
Another disadvantage of a DRIP plan is the increasing shares. Companies are authorized to issue a max number of shares, and this number differs from the number of shares outstanding. Therefore, whenever someone wishes to purchase additional shares through the DRIP program, more shares are issued, meaning that there are more in circulation.
Therefore, the increasing number of shares causes the value of specific, important financial ratios to change, such as Earnings per Share, which calculates how much profit is earned from each share outstanding. As a result, the increasing number of shares results in the Earnings per Share to lower in value, ultimately reducing investor confidence.
The lowering of investor confidence causes the share price to dip, negatively impacting the investor’s portfolio value in the short run. Thus, the minor, short-term lowering of the stock price resulting from this investment method is not for individuals who prefer to trade stocks in the short term.
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For DRIPs, any dividend and share purchase must be accurately accounted for. Therefore, any activity is recorded because shares purchased through a DRIP are seen as taxable income. In addition, at the end of the year, the capital gains and losses earned are also taxed, meaning if a substantial gain was made from an investment involving shares acquired from the DRIP, a portion of the profits must be paid back to the IRS when filing taxes.
Loss of Income Stream
Dividend-paying stocks appeal to investors as they offer an additional stream of income, allowing them to invest in other opportunities in the stock or real estate market. However, as a DRIP automatically reinvests its dividends, this revenue stream is essentially removed.
Thus, although this investment plan is beneficial to investors aiming to maximize their retirement income, it does not suit those who wish to utilize their dividend income on other investment opportunities or personal spending.
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Trading Platforms that Offer Dividend Reinvestment Plans
With the pros and cons of a DRIP being covered, the following section discusses some of the most popular trading platforms which offer a DRIP to their investors.
The first trading platform that offers a DRIP is TD Ameritrade. This platform allows users to sign up for free and offers fractional shares. If the dividend received by the investor is insufficient for a whole share, they can use the dividend income to own fractional shares.
Like TD Ameritrade, Charles Schwab allows users to reinvest cash dividends into financial securities. Furthermore, they also offer fractional shares if the dividend payout does not amount to the current price of the financial security.
Choosing which type is most suitable for you with many different investment methods can become quite challenging. With each unique investment technique having distinct advantages and disadvantages, many struggle with choosing the method that meets their needs
Finding the ideal investment technique is key to maximizing the gains you receive later in your life. Hopefully, the information disclosed above regarding the different aspects of a DRIP can make your decision on which investment method to choose an easier one.
Disclaimer: The information in this article should not be considered financial advice. Always do your own research prior to investing. CapWay is not liable for any losses which may be incurred.
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