One of the ways investors can start earning a profit from their investments is through dividends. As a way to share the wealth, some companies will pay investors periodic payments known as dividends when they’re earning enough money to cover their basic expenses.
There are a lot of ways you can use these funds. Some investors might decide to pocket the money, especially if they have other pressing financial needs. But investors who are in it for the long game might choose to reinvest their earnings back into the company and give their money the chance to continue to grow and compound, and it’s common for companies to facilitate this through dividend reinvestment plans (DRIP).
What is a DRIP?
A DRIP is a plan that lets investors reinvest any dividends they receive back into the company’s stock—usually at a discount. It’s important to note that while this is a way for long-term investors to put even more money behind their investments at a lower cost, these investments are still taxable (more on that later).
There are a three main types of dividend reinvestment plans:
- Company-operated DRIP: When a company operates its own DRIP and there is a designated department that manages DRIP plans.
- Third-party-operated DRIP: As a way to cut costs and save time, some companies outsource their plans to a third party that handles the entirety of the plan.
- Broker-operated DRIP: Some companies may not offer a DRIP at all, but brokers may provide a DRIP on some investments to investors. With a broker-operated DRIP, brokers purchase shares on the open market. Brokers may or may not charge a small commission for DRIP stock purchases.
How do DRIPs work?
DRIPs work by reinvesting a set amount of earned dividends on the date they are usually paid out. “You purchase additional fractional shares of the stock on the date the dividend is paid,” says Philip Weiss, financial advisor and founder at Apprise Wealth Management. “The term can apply to any automatic arrangement that allows you to reinvest the dividends you receive in an account held at a brokerage or investment company.”
This kind of plan implements an investment strategy known as dollar-cost averaging, which involves making investments of equal amounts, at regular intervals, regardless of how the stock market is performing. For investors who have a difficult time keeping their hands off their portfolio when the market is bumpy, DRIPs can not only help automate investing but can also help spread out some of the risk they assume by continuously investing no matter what the market is doing.
Pros and cons of DRIPs
Pro: DRIPs are one way to automate your investing strategy. When you opt to have your dividends automatically reinvested, it’s one less financial to-do on your list. It also keeps you accountable to your long-term goals, even when the market is shaky and you may be tempted to react in the moment—a move that could potentially cost you more in the long-run.
Pro: Shareholders can score a discount. DRIPs can help you cut costs. “Some companies allow you to purchase shares through a DRIP at a small discount [of] 1%–10%,” says Weiss.
Con: Shareholders could end up paying higher share prices. Because shares are automatically purchased, investors may end up investing at a time when prices are on the higher end.
Con: DRIP plans could throw your portfolio off balance. Overexposure to a particular company could hurt you in the long-run if your portfolio doesn’t have a good mix of assets.
How DRIPs impact your taxes
DRIPs can be beneficial for investors in more ways than one. But there are still tax implications even if the funds go directly back into the company you’ve invested in.
“Under the tax rules, any time an investor has a choice between receiving a cash dividend or additional shares, the shareholder gets taxed on the cash value of the dividend,” says Weiss. “Reinvested dividends are taxed the same as cash dividends. But the amount of the dividend gets added to your basis in the shares. This means that you will have a smaller gain (or a larger loss if the investment works against you) if [or] when you sell the shares in the future.”
The takeaway
DRIPs can offer long-term investors a way to save money as they continue to invest in the same company over time. However, it’s important to weigh your long-term goals with your short-term needs to determine if participating in a DRIP makes sense for you.
