What Is a Dividend Reinvestment Plan (DRIP)?
A dividend reinvestment plan (DRIP) is a program that allows investors to reinvest their cash dividends into additional shares or fractional sharesof the underlying stock on the dividend payment date.
Although the term can apply to any automatic reinvestment arrangement set up through a brokerage or investment company, it generally refers to a formal program offered by a publicly traded corporation to existing shareholders.
Key Takeaways
- A dividend reinvestment plan, or DRIP, automatically uses the proceeds generated from dividend stocks to purchase more shares of the company.
- This strategy allows investors to compound their returns over time by accumulating more shares, which themselves pay dividends that will be reinvested.
- Note that dividends paid into DRIPs are taxed even though they are used to purchase shares.
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Understanding a Dividend Reinvestment Plan (DRIP)
Normally, when dividends are paid, they are received by shareholders as a check or a direct deposit into their bank account. DRIPs, which are also known as dividend reinvestment programs, give shareholders the option of reinvesting the amount of a declared dividend into additional shares, which are bought directly from the company.
Because shares purchased through a DRIP typically come from the company’s own reserve, they are not marketable throughstock exchanges. Shares must be redeemed directly through the company, also.
Most DRIPs allow investors to buy shares commission-free or for a nominal fee, and at a significant discount to the current share price; they may set dollar minimums. However, most do not allow reinvestments much lower than $10. While DRIPs are usually intended for existing shareholders, some companies do make them available to new investors, usually specifying a minimum purchase amount.
Although the shareholder does not actually receive the reinvested dividends, they still need to be reported as taxable income (unless they are held in a tax-advantaged account, like an IRA).
Note
While most DRIPs use the cash proceeds from dividends to purchase additional shares, more complex methods can occur if the dividend itself is granted in stock in lieu of cash.
Advantages of DRIPs
There are several advantages of purchasing shares through a DRIP, for both the company issuing the shares and the shareholder.
Advantages for the Investor
DRIPsoffer shareholders a way to accumulate more shares without having to pay a commission. Many companies offer shares at a discount through their DRIP.
Between no commissions and a price discount, the cost basis for owning the shares can be significantly lower than if the shares were purchased on the open market. Through DRIPs, investors can also buy fractional shares, so every dividend dollar is really going to work.
Long term, the biggest advantage is the effect of automatic reinvestment on the compounding of returns. When dividends are increased, shareholders receive an increasing amount on each share they own, which can also purchase a larger number of shares.
Over time, this increases the total return potential of the investment. Because more shares can be purchased whenever the stock price decreases, the long-term potential for bigger gains is increased.
Advantages for the Company
Dividend-paying companies also benefit from DRIPs in a couple of ways. First, when shares are purchased from the company for a DRIP, it creates more capital for the company to use. Second, shareholders who participate in a DRIP are less likely to sell their shares when the stock market declines.
Partly that's because participants tend to be long-term investors and recognize the role their dividends play in the long-term growth of their portfolios. Of course, another factor is that DRIP-purchased shares are not as liquid as shares purchased on the open market—they can only be redeemed via the company.
Most DRIPs, such as the one discussed here, are sponsored by a company (issue-sponsored) through their transfer agent, who holds the shares. Note that some brokerages allow customers to participate in a transfer agent DRIP while keeping the shares at the brokerage firm. In a broker-sponsored DRIP, the broker buys the share using the dividend proceeds in the open market.
Example of a DRIP
3M offers a DRIP program. It is the Automatic Dividend Reinvestment Plan administered by the company's transfer agent, EQ Shareowner Services. The plan allows for quarterly cash dividends to be automatically reinvested in purchasing 3M stock. The company pays all fees and commissions.
What Is the Downside to Reinvesting Dividends?
Reinvesting dividends means you don't receive the cash from the dividend which could be used for other purposes, such as spending it or investing it elsewhere. You also may have to pay taxes, and if you don't receive the cash payout, you're paying taxes from your own funds.
How Do I Avoid Paying Taxes on Reinvested Dividends?
Dividends are taxed as capital gains if they are qualified dividends or as ordinary income if they are nonqualified dividends. The only way you can avoid paying taxes on reinvested dividends in the year they're earned is by holding those stocks in a tax-advantaged plan, such as a 401(k).
Why Do Companies Pay Dividends Instead of Reinvesting?
There can be many reasons why companies pay dividends instead of reinvesting. Paying dividends is a sign of financial strength showing that a company is performing well enough to not only run its business successfully but share that success with its shareholders. It also makes a company's stock more attractive to investors.
The Bottom Line
Some companies pay out dividends, which is a beneficial feature of owning their stock, allowing for fixed income to be distributed to the shareholder.
While many dividends are paid in cash, some companies offer dividend reinvestment plans (DRIPs), which allow for the purchase of additional shares using dividends. If an investor believes the stock is a good value, this can be beneficial for their portfolio, especially since no fees and commissions are charged.
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