Dividend reinvestment plans or DIPs offer great compounding investment benefits to shareholders. You can take out all of the dividends offered by a company in cash. A DRIP lets you reinvest all or some of the dividends back into the stocks you already hold.
Dividend reinvestment plans are offered by a company itself directly or through a third-party service management company. These plans are optional subscriptions for existing shareholders.
Often, additional stocks are offered at a discount from the market share price and with a no-fee advantage to attract investors.
Investing in a DRIP is a long-term investing strategy. It can bring good fortunes for you in the long run. However, it can come at some opportunity costs to you.
Let us analyze the idea of investing through a dividend reinvestment plan.
What is a DRIP?
A Dividend Reinvestment Plan is a formal offer by a company to its existing shareholders to reinvest the dividend in the form of additional stocks.
A shareholder has the option of subscribing to additional stocks instead of receiving cash dividends. Companies offer these additional stocks at discounts and with low commission costs to attract shareholders.
DRIPs are optional plans for shareholders, not an obligation. Shareholders can enroll in a DRIP plan operated by a company or a brokerage firm. Automatic subscriptions to DRIPs can save you brokerage commission and transaction costs.
How Does a DRIP Work?
A company offers a DRIP when it wants to retain shareholders and the capital at the same time. Cash dividends often take a toll on the free cash flows of a company. A DRIP provides an alternative option for these companies.
A company’s dividend reinvestment plan can be offered directly through a third-party service provider or a brokerage firm. These plans are offered to existing shareholders; however, new investors can also subscribe in some cases.
As the dividend reinvestment plan is offered in additional stocks from the company, these stocks cannot be exchanged in the stock market. Shareholders can redeem these stocks from the company only. Thus, it limits the liquidity of additional stocks a little as compared to other stock options.
Getting Started with Investing through a DRIP
As with any other form of investment, your first step will be to conduct thorough stock research. Not all stocks pay dividends, and it is also noted that not all dividend stocks offer DRIPs. Also, return of investment, EPS, DPS, and growth rate of dividends are key factors to evaluate before subscribing to a DRIP.
An advantage to shareholders with a DRIP is established firms and brokers offer these programs. Small companies cannot afford the administrative costs of running a DRIP. Thus, finding a suitable DRIP for investing should be fairly easy.
Consider investing in a dividend reinvestment plan if you want to hold the investment for the long run. Compounding investment is the biggest advantage with reinvestment plans. You can only achieve capital gains if you can hold the investment for a longer period.
You can enroll in a DRIP offered by a company directly or through a brokerage firm. For instance, Coca-Cola operates its DRIP by itself. Direct reinvestment plans can save you commission costs as well. Some companies impose a minimum and a maximum subscription limit for a dividend reinvestment plan too.
Tips for Investing Through DRIPs
Once you decide to reinvest the dividends instead of cash withdrawal, you can plan to make it successfully work for you. Remember, you’ll need an investment plan just like you need one for stock investments.
Here are a few quick tips for you to invest in DRIPs a good idea.
- Choose the right stocks for DRIP investments. A stable company with a long dividend history should be your priority here. In a nutshell, a blue-chip stock with a long history should be your go-to option here.
- Plan to hold the investment for a longer period to take full advantage of the compounding effects. DRIP investing is a long-term approach.
- Look for low-cost brokerage accounts that offer no-fee or lower commission costs. For instance, Vanguard offers a $7 and Trade King offers a $ 4.95 commission structure.
- Plan for tax efficiency with a DRIP. Your dividend reinvestment is also taxable income unless you hold it for a tax-efficient plan like a 401(k).
- Do not rely only on the automation of dividend reinvestment programs. Always follow the market and try to match it with adjusted plans.
Dividend Reinvestment Plans – Pros Explained
Dividend reinvestment plans can be your go-to option if done properly. First thing, it shouldn’t be considered a short-term trading strategy. It’s a long-term investing approach that requires reinvesting for the long run.
Companies operating a DRIP offer reinvestment plans with discounted share prices. These companies typically offer a 10-15% discount on the market share price to attract shareholders.
Lower Trading Costs
Like discounts on stock prices, you’ll get discounts on trading costs on dividend reinvestment plans. Brokerage firms also offer discounts on commission costs to attract investors for a dividend reinvestment plan.
Although your dividend income and reinvestment income will be taxed, they will come at a lower tax rate. Domestic Corporations’ dividends are taxed at a lower capital gain’s tax rate than other income.
When you enroll in a DRIP, you buy more shares at discounted prices. Hence, it brings the overall share costs down for you in the long run. Thus, you can take advantage of automatic dollar-cost averaging with a DRIP.
Shareholders usually subscribe to a DRIP with automation. Thus, you can immediately reinvest at discounted share prices without delay.
Dividend Reinvestment Plans – Cons Explained
If done properly, DRIPs can bring several investing benefits to you. However, these plans also come with some disadvantages to investors.
When you reinvest through a dividend reinvestment plan, you forego the cash dividend. Many shareholders buy dividend stocks for regular income. Reinvesting offers an opportunity cost that you have to decide on.
Lack of Diversification
As you automatically reinvest in stock for a longer period, your portfolio becomes concentrated. It may create a lack of diversification in your investment portfolio which you may need to adjust from time to time.
Although you can take advantage of lower capital gains taxes through a DRIP, your income will still be considered as taxable income. Thus, you’ll naturally incur higher income tax costs with a DRIP enrollment.
Lack of Flexibility
Companies offering dividend reinvestment plans can offer it at a time with overvalued share prices. Thus, shareholders will be left with buying overvalued stocks even after discounts.
Enrollment to DRIPs means shareholders can redeem additional stocks from the company only. These additional stocks cannot be exchanged in the stock market as well. Thus, it can create liquidity issues for investors.
Dividend reinvestment plans can bring several benefits to shareholders. If you plan for long-term capital gains and choose the right stocks, DRIPs are ideal for you. You can accumulate compounding benefits and take advantage of lower trading costs with DRIPs.
At the same time, you must not rely on the automation of DRIPs only. You should carefully select the right stocks for dividend reinvestments. Always consider the opportunity cost that comes with reinvesting a dividend.