When shareholders receive dividends from a company or investment fund, they may have the option to either receive the dividends as cash or use the dividends to buy more shares of the company or fund. If they choose to buy more shares, they can do so through a dividend reinvestment plan, or DRIP, which automates the process of reinvesting dividends to buy additional shares.
What is a dividend reinvestment plan (DRIP)?
A dividend reinvestment plan, or DRIP, is an option offered by many companies, brokerages, exchange-traded funds (ETFs) and mutual funds that allows investors to use their dividends to buy more shares of the company or fund without having to initiate a transaction themselves. This automated process is intended to simplify the process of building wealth through compound returns. Some DRIPs have minimum requirements, such as holding dividends until a certain amount is reached before reinvesting, and some offer the ability to purchase fractional shares. There are pros and cons to investing in DRIPs, including the potential for quicker returns and automation, but also the possibility of buying shares at an undesirable price.
How dividend reinvestment plans work
When a company or investment fund pays dividends to its shareholders, the shareholders are typically given the option to either receive the dividends as cash or use the dividends to buy more shares of the company or fund. If they choose to buy more shares, one way to do this is through a dividend reinvestment plan, or DRIP.
DRIPs are offered by many companies, brokerages, ETFs, and mutual funds. They allow investors to automatically reinvest their dividends in the company or fund without having to initiate a transaction themselves.
When an investor opts into a DRIP, their dividends are typically held in reserve until they reach a certain amount or until the investor accumulates a certain number of shares. For example, a DRIP may require investors to accumulate $10 in dividends before they can be reinvested. Once the minimum is reached, the dividends are used to buy more shares of the company or fund.
In some cases, the shares purchased through a DRIP are bought directly from the company or fund, rather than through a public stock exchange. This can allow investors to buy shares at a discounted price.
Many DRIPs also offer the option to purchase fractional shares. This means that investors can use their dividends to buy a small piece of a share, rather than having to wait until they have enough dividends to buy a full share. This can help put investors' money to work sooner and make it easier to buy into stocks that have a higher price. For example, if a stock costs $150 per share and pays an annual dividend of $2.615 per share, it may be difficult for an investor with only a few shares to accumulate enough dividends to buy a full share. With fractional shares, the investor can use their dividends to buy a small piece of the stock and then add to their position over time.
Pros and cons of DRIP investing
Advantages of dividend reinvestment plans
- DRIPs can help investors put their money to work sooner. Dividend reinvestment allows investors to use their dividends to buy more shares without any delay, which can help them build their investment portfolio faster. If a DRIP offers fractional shares, investors can use their dividends to buy a small piece of a stock right away, rather than having to wait until they have enough dividends to buy a full share. This can help investors take advantage of the power of compounding, where the returns on their investments generate additional income and potential for growth.
- DRIPs automate the reinvestment process. Without a DRIP, investors have to manually reinvest their dividends by choosing an investment and actually processing the transaction. This can lead to delays and the potential for human error, which can cost investors money. A DRIP eliminates this hassle by automatically reinvesting dividends as soon as they are received.
- Some DRIPs offer discounts on shares. Some companies and funds may offer shares at a discounted price when purchased through a DRIP. This can save investors money and allow them to buy more shares.
Disadvantages of dividend reinvestment plans
- Shares may not be offered at the preferred price. With automatic dividend reinvestment, investors have no control over when new shares are purchased or at what price. In some cases, this may mean paying more for a stock than they would like.
- Investors may need to use their dividend income for other purposes. Dividend reinvestment plans only work if investors have enough dividend income to reinvest. If investors need to use their dividends for other expenses, such as paying bills or saving for a down payment on a house, then a DRIP may not be the best option.
- DRIPs may not be the best option in all market conditions. In a rising market, investors may be better off using their dividends to buy more shares of a stock that is appreciating in value. In a falling market, they may be better off selling their shares and using the dividends to buy other investments that are more likely to generate a return. A DRIP may not offer investors the flexibility to respond to changing market conditions.
Are DRIPs taxable?
A dividend reinvestment plan isn’t an investment in and of itself. Rather, it is simply a mechanism that automates the process of reinvesting the dividends investors have already earned, in order to purchase additional shares of stock. For this reason, there isn’t a dividend reinvestment tax, per se.
That said, the dividends processed through a DRIP may be taxed in a few different ways, depending on:
- The company itself
- How long the investor has held the stock
- The investor’s taxable income
Dividends may be qualified or unqualified, also known as ordinary. Ordinary dividends are taxed as ordinary income at investors’ normal tax rate.
Qualified dividends are offered by eligible US-based and foreign corporations to investors who meet holding period requirements. These dividends are taxed at either 0%, 15%, or 20%, depending on the investor’s overall taxable income for that year.