How Do Dividend Reinvestment Plans (DRIPs) Work?

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Updated on Friday, December 21, 2018

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Many stocks pay dividends, which are the portions of profits companies share with investors. Shareholders typically have the option of receiving those dividends in cash — often by having the funds deposited into their brokerage account. Some companies provide an additional option. Shareholders also can choose to reinvest the dividends in additional shares of stock by way of a program called a dividend reinvestment plan (DRIP).

A DRIP is an alternative that allows shareholders to use dividends to buy additional shares instead of receiving the dividends in cash. Although the terms vary slightly from company to company, each time a dividend is issued, the company (or its transfer agent) uses the money to buy additional whole and fractional shares of stock and credits them to your account.

Company DRIPs

Hundreds of companies offer DRIPs. The requirements to participate are fairly simple.

  • First, you need to have shares of a company with a DRIP program registered in your own name (as opposed to held in a brokerage account, where the shares typically are registered in “street” name).
  • Next, you need to contact the company, typically through its shareholder (or investor) relations department, to sign up for its DRIP. Companies typically offer online sign-up, or you can do so with a brief telephone call.
  • When the company pays its next quarterly dividend — instead of giving you a cash payout — it will reinvest your dividend in whole and fractional shares of its stock based on the total dividend amount.

While some companies open their DRIPs only to current shareholders, others allow new investors to enroll and may impose a minimum initial purchase requirement to get started in the program. Lowe’s (LOW), for example, allows new investors who either invest $250 or agree to 10 regular purchases of $25 to enroll in the company’s DRIP.

Other terms also vary from company to company, with some requiring a minimum dividend amount. The cost of participating in the plan is nominal, typically a small fee imposed by the company’s transfer agent. Most companies similarly impose small fees for purchases and sales. At AT&T (T), for example, the initial account setup fee is $10 and dividend reinvestment costs 5% of the dividend amount to a maximum of $3. Most companies also impose small fees to sell shares. Campbell Soup Company (CPB), for instance, charges $25 (as of Dec. 19, 2018).

Redeeming shares is just as easy. Contact the company or its transfer agent and say how many shares you want to sell. Then, the company will send you a check for the proceeds, less any fees.

For example, Marie owns 500 shares of stock in XYZ Company. The company pays a quarterly dividend of $1.25 a share. That means Marie is entitled to receive $625 in dividends each quarter. Instead of receiving those dividends in cash, Marie enrolls in XYZ’s DRIP. For a nominal annual fee (but no brokerage commissions) XYZ uses the quarterly dividend to buy additional shares on Marie’s behalf.

Assume that on the day the company pays its most recent dividend, XYZ is trading for $62.50 a share. That means the company uses Marie’s dividend to buy her 10 additional shares. Assuming the company’s stock price remains relatively stable, Marie’s participation in the DRIP plan will yield her roughly 40 additional shares per year (not including the dividends on the shares the plan buys).

Brokerage firm DRIPs

Many discount and full-service brokerage firms offer their customers the opportunity to enroll virtually any stock that pays a dividend in the firm’s DRIP. You can enroll a stock you already own or select a new stock. If you choose the latter, most firms require either a minimum initial purchase of, say, $500 or regular purchases over time.

The process of enrolling in a DRIP from a broker is similar to participating in a company dividend reinvestment plan.

  • Contact your broker to enroll a specific stock in the program.
  • Then, instead of crediting dividends to your account, the firm will use them to buy full and fractional shares when the company pays its dividend.
  • If the stock is one you don’t already own, meet the initial purchase requirements the broker imposes.

Most firms impose small fees for account setup, for subsequent reinvestment of dividends and for sales, similar to those described above. Redeeming money from the account is as simple as contacting your broker and saying how many shares you want to sell.

Many dividend reinvestment plans, both company and brokerage, offer participants the opportunity to invest additional dollar amounts through regular withdrawals from their checking or brokerage accounts. In the example above, Marie could elect to have $50 a month withdrawn from her checking account to buy additional shares of XYZ Company stock.

The benefits of DRIPs

DRIPs are a great way to save for future goals, such as retirement or your kid’s college education. But they don’t offer any income tax benefits. The dividends you elect to reinvest in additional shares are taxable to you when the company pays them — regardless of whether you elect to receive them in cash or use them to buy more shares.

Jayson Owens is a certified financial planner and financial advisor working for Bright Road Wealth Management with offices in Tacoma, Washington, and Anchorage, Alaska. He recommends to his clients that they take advantage of DRIPs. Many people think a dividend reinvestment plan is an investment type, but Owens said, “Really, it’s just a feature most investment platforms offer where you automatically reinvest any dividends in more shares. The upside is if you don’t need the income, your investment can continue to grow instead of sitting idle.”

The No. 1 problem with saving for retirement, according to Owens, “is saving for retirement.” Owens believes dividend reinvestment plans are a great way to save for the future. When most sources cite the long-term return of a particular stock or mutual fund, there usually is a footnote, Owens said, that includes reinvestment of dividends.

“Historically, one-third of long-term market return represents dividends,” according to Owens. Another advantage of DRIPs is that you are paying taxes on the dividend income out of cash flow and not out of the dividend. This means even more money is going to work for you if you reinvest using a DRIP.

There are, of course, some drawbacks to investing through a dividend reinvestment plan. First, you lose the income from your dividends because you are reinvesting the proceeds in new shares. Second, you are purchasing shares at regular intervals rather than when you judge it to be the right time to invest. In addition, most companies impose small fees for account setup, reinvestments and sales. But these fees generally are less than the commission you might pay through a broker to complete the same transaction.

Why good record-keeping is critical

So you can calculate any capital gains when you sell shares of stock held in a DRIP, it’s essential to practice good record-keeping.

Returning to Marie’s example above, her cost basis for the 10 shares of stock she buys is $625 — the amount of the taxable dividend she reinvested in additional shares through the DRIP. Since the stock price is likely to vary somewhat over time, Marie’s $625 quarterly dividend is likely to buy a slightly different number of shares each time. If Marie liquidates those 10 shares two years later when the stock is trading for $75 a share, she will have a $125 long-term gain — the difference between the $625 she paid and the $750 in sale proceeds she receives.

Mutual fund reinvestment of dividends

Although not necessarily called a DRIP, mutual fund investors generally can follow the same reinvestment strategy. Most mutual funds allow you to either receive your dividends and capital gains distributions in cash or check a box and reinvest them to buy more shares. If you don’t need the dividends and capital gains to fund other expenses, reinvesting them is a great way to see your investment in a mutual fund grow even faster.

Bottom line

Dividend reinvestment plans are a relatively painless way to build capital for the future. Particularly for younger investors — whose wages typically cover their living expenses — a DRIP is an easy way to make sure dividends are immediately put to work to secure a future goal, whether it be retirement, educating a child or funding a special family vacation.

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