DRIPs – What are Dividend Reinvestment Plans and How Do They Work?

Overview

A dividend reinvestment plan refers to a reinvestment plan where shareholders have the option of reinvesting cash dividends into underlying stocks they hold. A dividend reinvestment plan DRIP for short thus provides a flexible option of buying more stocks to the existing shareholders without paying brokerage fees or commission.

A DRIP comes with several advantages for the issuing company and the shareholders. Compounding growth of the underlying investment is the most significant advantage for investors, though.

Let us understand the concept of the Dividend Reinvestment Plan.

What is a Dividend Reinvestment Plan (DRIP)?

Companies paying dividends offer a formal plan to their existing shareholders to reinvest the dividends and receive additional shares in return. This reinvestment plan refers to the Dividend Reinvestment Plan or DRIP for short.

A DRIP offers an automatic reinvestment plan that brings more shares for existing shareholders. Usually, the plan is offered by the company to its existing shareholders only. However, the plan can also be offered to new investors.

Most companies offer dividends in the form of cash. Investors also use dividend stocks for regular income. In some cases, a company facing liquidity issues may want to continue its dividend program. A DRIP is a popular alternative in such scenarios as it does not need to pay direct cash to its shareholders.

How Does a Dividend Reinvestment Plan Work?

Existing shareholders are usually entitled to a dividend reinvestment plan. A company can offer the plan directly or through third-party service providers. Shareholders on ex-dividend date receive dividends. Hence, the same shareholders become eligible to participate in the reinvestment plan.

When a company offers a DRIP, its existing shareholders have the option of buying additional stocks. The company may offer these additional stocks at a discount to the market share price to attract investment. The discount can be offered in percentage terms to the market share price on a particular date.

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As the company offers the DRIP and additional shares are issued, the reinvestment shares cannot be traded on the exchange directly. Investors participating in the DRIP can purchase additional shares only. They would also need to redeem the additional shares from the company directly.

Not all companies paying dividends offer a DRIP. However, companies with a reinvestment plan always attach a sweetener to attract investors. For instance, many companies offer reinvestment plans with no brokerage commission. Also, many companies offer additional shares at a discount to the market share price. Thus, investors can save more and hold a more significant proportion of shares than without a reinvestment plan.

The compounding effect of reinvestment that yields higher capital gains in the long-term is the biggest attraction for investors with a DRIP. S&P 500 is a prime real-world example of generating long-term capital gains through the reinvestment compounding effect.

Example

Suppose you own 500 shares of a company ABC. The current share price of the ABC company is $100. It announces a dividend reinvestment plan with a 10% discount and no commission. The ABC company declares a dividend of $5 per share to its shareholders.

For simplicity, we assume you fully participate in the DRIP. You receive a dividend of $2,500 (500 ×5) on the payment date. With a DRIP, you are entitled to a 10% discount on the share price. Your dividend amount enables you to buy additional 27.77 shares or 27 shares. After subscribing to the plan, you now own 527 shares at the same market value of $100. Thus, your capital investment increases from $50,000 to $52,700 without additional cash payment.

Types of Dividend Reinvestment Plans

Many companies offer a direct dividend reinvestment plan to their shareholders. For instance, large companies like Coca-Cola handle their DRIPs by themselves. However, not all companies can afford or manage the plan. Hence, it can take a few different types by the type of service provider.

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Company-Operated DRIPs

Some large companies offer a dividend reinvestment plan directly to their shareholders and manage the plan without a broker.

Third-Party DRIPs

Many companies arrange these plans through specialized third-party service providers. Cost and management are two prime objectives behind offering these plans through third-party service providers.

In both types, the shareholders may need to pay some commissions for a subscription. However, these costs would be lower in a company-offered plan.

Brokerage DRIPs

Many brokers offer DRIPs on their own. Your investment is automatically reinvested through a share subscription. Many brokerage firms offer these programs to the investors for individual stocks or funds.

DRIPs and Taxation

Shareholders need to pay dividend tax. Similarly, they need to report additional stocks purchased through a DRIP. Although investors do not receive these dividends in cash form, these are still treated as taxable income.

The only waiver of taxes comes through holding investments in a tax-advantaged program such as a 401(k).

Taxes on these plans are an essential reason for companies offering discounts on these additional shares. Low commission and share price discounts are offered to compensate investors for their tax costs.

Advantages of Investing in a Dividend Reinvestment Plan

Dividend reinvestment plans offer different advantages to existing shareholders and the company itself.

Compounding Returns

The compounding effect of reinvestments is the biggest advantage to shareholders with DRIPs. Although investors utilize dividends in the cash form, a DRIP offers a useful alternative for reinvestment and capital gains.

Discount on Share Prices

Shareholders can subscribe to more shares at a discounted price. Offering discounts do not come as a guarantee, though. However, a DRIP is more likely to offer share price discounts to attract investors.

Low Brokerage Commission

Company-operated and brokerage DRIPs usually offer lower brokerage commissions to attract shareholders. Thus, existing shareholders can take advantage of lower brokerage costs to pay otherwise to buy new shares.

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Retaining Shareholders

DRIPs offer a few advantages to the company as well. When existing shareholders subscribe to a dividend reinvestment plan, they are likely to retain the ownership of stocks. Thus, a company can retain its shareholders for a longer period with a DRIP.

Increased Capital

A company would need to pay cash dividends to its shareholders without a DRIP. Thus, companies with DRIPs retain and increase capital. At the same time, they satisfy their shareholders and avoid negative news about their shares.

Disadvantages of Investing in a Dividend Reinvestment Plan

A dividend reinvestment plan comes with several limitations for the company and shareholders as well.

Liquidity Issue

Shareholders cannot exchange additional shares received through DRIPs on stock exchanges. They can only be redeemed through the company or the brokerage house offering these shares. Thus, it limits the liquidity of additional shares for shareholders.

Dilution of Shares

A company would need to offer additional shares to its existing shareholders to dilute shareholding for non-participating shareholders. Also, the company would have an increased number of outstanding shares that can affect its share price.

Lack of Control for Shareholders

A DRIP can be subscribed to at specified conditions and prices offered by the company. Thus, a shareholder may have to subscribe at a time when share prices are too high.

Long-term Investment Horizon

Subscription to a DRIP does not bring short-term investment benefits. Shareholders cannot exchange these shares in the stock market. Thus, shareholders would need to consider a long-term investment horizon with a dividend reinvestment plan.

Taxation

Although shareholders do not receive cash dividends, it is treated as taxable income by the IRS. Thus, a DRIP would incur tax implications for the subscribing shareholders.

Diversification

Shareholders regularly subscribing to a DRIP can lack diversification in their investment and investment, concentrating more on a single asset.

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