What are Dividend Reinvestment Plans?
Dividend Reinvestment Plans (DRIP) are plans in which investors can purchase new or fractional shares in a company at a discount using dividends issued by it. The plans can be administered automatically or manually. DRIPs enable investors to boost their holdings in a company by purchasing shares at cheap prices. Such plans compound wealth by increasing returns steadily over a period of time through investment in a company that is doing well. But they can also result in significant losses, if the company does not do well.
Basics of Dividend Reinvestment Plans
Over 1000 companies and closed-end funds in the stock market have dividend reinvestment programs. For example, prominent companies like oil giant Exxon Mobil and pharma giant AbbVie Inc. operate their own dividend reinvestment programs.
For companies, the advantage of such programs is that such programs enable them to build a loyal base of investors who provide capital to the company through periodic investments. The advantage for investors in these companies is that they can get ownership of stock in these companies at a discount and without using any of their own money.
DRIPs calculate stock price using dollar cost averaging. In this technique, the average of a stock’s price between its highest and lowest price is calculated over a period of time. This is the price at which DRIP shares are sold to investors.
Over time, as their shareholdings in a company increases, investors receive more dividends to purchase more shares at a discounted price. This effect, known as compounding, increases their returns from the investment. While compounding does not offer the instant returns of trading, it builds capital over the long term. According to some studies, DRIP can generate more returns as compared to other forms of investment when measured over a long period of time.
Types of Dividend Reinvestment Plans
There are two types of Dividend Reinvestment Plans.
- In a Full Enrollment DRIP, an investor commits their entire shareholding to the plan. This means that they will reinvest dividend payments from their entire holding to purchasing additional shares in the company.
- In a partial enrollment, an investor commits only a specific number of company shares to the reinvestment program. Dividend payments for the remaining block of shares not committed to the program are not used to purchase additional shares of the company.
Example of Dividend Reinvestment Plan
Suppose Aaron owns 100,000 shares of Apple’s stock, which is priced at $500 per share, and he has enrolled in a full enrollment dividend reinvestment plan with a brokerage. Apple hands out a quarterly dividend of $0.82 per share. At the end of the first quarter, Aaron receives $82,000 in dividend payments. Since he has enrolled in DRIP, that amount will be used to purchase 164 more Apple shares. Assuming that Apple prices shares at $500 for DRIP recipients, Aaron will own 100,656 shares by the year’s end without investing a single cent of fresh capital.
How can you invest in a Dividend Reinvestment Plan?
The first step to making a DRIP investment is to buy shares of a company that pays out regular dividends. The S&P’s Dividend Aristocrats list is a good place to start. The list contains companies that have regularly paid out increasing dividends over the last 25 years.
Certain large companies have their own DRIP programs with qualification criteria attached to them. For example, they might require a minimum investment or have fees associated with them. Brokerages and third-party providers also offer DRIP programs for their customers. Some have commissions while others do not.
You can also craft your own DRIP program by conducting research and investing in dividend paying companies. Based on a final income target, you will need to reinvest dividend proceeds to purchasing shares in the same company.
For the most part, dividend reinvestment plans are automatic, meaning the crediting of accounts and share repurchase occurs automatically. Investors enrolled in DRIP programs are issued shares instead of cash dividends. In the example above, Aaron’s brokerage account will be credited with an additional 164 shares at the end of the first quarter instead of the dividend amount owed to him by the company.
Taxes and DRIP
Dividends are taxable, per IRS rules, whether in cash or share form. Therefore, DRIPs are taxed at regular income tax rates. But capital gains taxes are only due at the time of the stock’s sale.
Selling DRIP shares
DRIP shares are not part of a company’s float, or the number of shares that it has floated in the stock market. Instead, these shares are picked from internal equity. Therefore, in a company-operated DRIP plan, the shares must be sold back to the company. In a brokerage-operated DRIP plan, the shares are picked out from secondary markets and are sold back in those markets at the available trading prices.
Pros and Cons of Dividend Reinvestment Plans
The advantages of dividend reinvestment plans are as follows:
- Companies can build a dedicated base of investors interested in the company’s long-term prospects using DRIPs.
- DRIPs offer compounding returns to investors through steady investment in performing assets.
- DRIPs enable investors to purchase company stock at cheap prices.
The disadvantages of DRIPs are as follows:
- They can turn into bad investments if the company performs against expectations.
- DRIPs may not be suited for retirement because the need for cash income is greater during that stage of life.
- DRIPs do not offer tax advantages as they are taxed similar to ordinary dividends.
- DRIPs can require considerable book keeping for large holdings because calculating the original cost basis for shares is not as simple as in the case of shares traded in the open market.
- DRIP shares can only be sold back to the issuing company and cannot be put for sale in the open market.