Dividend reinvestment plans, or DRIPs, have long been a way for the small money investor to build positions in a stock without incurring the steep fees you’d pay at a full-service brokerage behemoth.
Here’s how DRIP investing works in a nutshell: you simply make an initial investment in a company that pays dividends and offers a DRIP – as some 1,200 companies do – and every time that dividend is paid, it gets automatically reinvested (generally fee-free) in full and partial shares of stock. That compounds on autopilot over years and while helping build wealth, also removes emotional decision-making from your investing. Since you invest incrementally, and regularly, you have less chance to try to time the market or make other rash decisions. Yet, competition from discount brokerages and low-cost funds make DRIPs possibly less compelling nowadays.
Want to learn more about DRIP investing? Read on for an in-depth overview of how this investment style works, the advantages and disadvantages that come with it, and three points to consider before committing your cash.
- What is a DRIP?
- Types of DRIPs
- Advantages of DRIPs
- Considerations to Make Before Investing
- How to Enroll in a DRIP
What is a DRIP?
DRIP stands for Dividend Reinvestment Plan, and the name really says it all. A dividend, as you may already know, is a cash payout that’s awarded to shareholders of a company. The amount distributed to investors is typically calculated based on the company’s performance over the quarter or fiscal year. Rather than take your dividend money and run, DRIPs allow investors the opportunity to reinvest those dollars and purchase additional stock in the company.
One of the biggest benefits of dividend reinvestment plans is that they allow investors to accumulate shares at a lower cost than the market rate because investors can — depending on the type of DRIP account — buy from the company directly without commission or brokerage fees.
- DRIP = Dividend Reinvestment Plan
- DRIPs allow shareholders to reinvest their annual or quarterly dividends back into the company, rather than take the cash payout.
- DRIPs are an attractive and cost-effective offer, allowing investors to accumulate additional stock without commission or brokerage fees.
Types of DRIPs
Now that you have a better understanding of what DRIP investing is and how it works, let’s take a look at the different types of DRIP accounts available to investors.
- Company-operated DRIP: The company handles reinvestments on its own, eliminating commission and brokerage costs.
- Third party-operated DRIP: If the company is not financially or operationally equipped to handle DRIP management, they may outsource plans to a brokerage firm.
- Broker-operated DRIP: Not all companies offer dividend reinvestment plans, but your broker might. Basically, a broker can handle the reinvesting for you, typically, at a reduced commission rate.
Advantages of DRIPs
Anytime you’re thinking about putting your hard-earned dollars into a new investment vehicle, it’s a good idea to take a look at the pros and cons. Let’s take a closer look at the advantages DRIPs have to offer and why they may be a solid investment choice for you.
One of the biggest advantages DRIPs have to offer is their affordability, which is why they’re appealing to many beginning investors. When you buy stock via DRIP plan, you typically avoid commission fees, or incur them at a lower rate than you might investing in stocks on the open market.
But the savings don’t stop there — to encourage sustainable shareholder investment, many companies offer discounts on shares when investors enroll in dividend reinvestment plans.
2. Compounding effect increases return potential
If you’re hoping to make steady, long-term gains on an investment, the compounding effect of DRIP plans may work in your favor. Because you’ll have acquired additional shares, you’ll be entitled to more dividend payouts and ultimately, improve your dividend yield.
3. Long-term investments facilitate company growth
As for company benefits, DRIP investing can be an incredibly effective way of retaining capital in the long-term.
Considerations to Make Before Investing
As we mentioned before, it’s always a good idea to assess the pros and cons of an investment type or financial decision in general before you put any money on the line. While DRIPs can offer several big benefits, make sure to take a look at these considerations before investing.
DRIPs are known for their low fees since you generally avoid broker commissions when the dividends get reinvested. And a few even give you a 2-3 percent bonus in stock when you deposit money or each time the dividends get reinvested. But, some DRIPs do charge a commission and even a percentage of the dividend for reinvestment so you may not save any money at all by going direct. So do your homework. Directinvesting.com maintains a list of no-fee DRIPs.[http://www.directinvesting.com/search/no_fees_list.cfm]
But, as discount brokers have proliferated you can now set up “synthetic” DRIPs through many. After making an initial investment and paying the broker’s fee, you can ask that dividends get reinvested. Schwab, TD Ameritrade, and Fidelity all allow this, among others, for no additional fee. You can also hold these synthetic drips in a traditional or Roth IRA. However, brokers fail in that if you want to contribute any more than just your reinvested dividends you’ll have to pay the broker fee. With DRIPs, if you have an extra $25, $50, or whatever at the end of the month, and want to send it in, there generally is no additional charge. And some brokers won’t allow you to own partial shares, which means your money won’t reinvest quite so quickly.
2. Paperwork clutter
Historically this has been a major knock against DRIPs. Instead of having all your investments at the same broker and on the same statement, you may end up with multiple statements from different DRIPs, and lots of separate 1099s come tax season. Though recordkeeping has improved substantially over the years in regards to DRIPs, and new rules should make it better, calculating the cost basis for the IRS has often been a headache because you need to take into account all those reinvested dividends when it comes to evaluating and paying DRIP reinvestment tax.
Setting up a traditional DRIP can be a pain in itself. While some companies run their own programs and let you buy initial shares from it, many others require you to first buy some shares through a broker (and pay a broker’s fee). You’ll then need to transfer the shares to whichever company manages the DRIP program and may need to get the actual stock certificate.
Donald F. Dempsey, a fee-only Certified Financial Planner in Williston, VT, recommends finding a company that allows you to purchase the first share(s) directly – especially if the initial investment is going to be $250 or less, so any broker fee wouldn’t take too much of a bite. Or he says if the DRIP is being opened for a child, see if a parent or relative can gift a share so the child can start with no or low cost
3. Maintaining a balanced portfolio
DRIPs can inspire a certain level of loyalty in a stock, just be sure it’s not misplaced loyalty. You don’t want to be so (emotionally) invested in a stock that you hang onto it in vain. For instance, holding on to a DRIP in the banking sector could result in years of waiting for the dividends that were slashed during the height of the recession to turn course. DRIPs obviously don’t allow you to invest in the Googles and Apples of the world (which pay no dividends), so you may need to find the tech portion of your portfolio elsewhere. For many investing in low-cost index funds or ETFs – and having the dividends reinvest – may be the smarter choice for building a diversified portfolio. And keeping those funds, as well as any synthetic DRIPs you might have, housed at the same discount broker will allow for easier rebalancing.
How to Enroll in a DRIP
If after reviewing the pros and cons of DRIP investing you decide that it’s the right investment avenue for your financial situation, follow these steps to get started:
- Use DirectInvesting.com to search for and select a company with DRIP options
- Consider, or better yet, avoid those with setup fees or commissions
- Register yourself as a shareholder and start buying stock
- Tailor your investment strategy as needed, and reach out to a financial advisor should you need additional guidance
Investing in a DRIP can be a lucrative move for your portfolio, but it’s important to consider both investing tips and investing mistakes as you find your way. Use the Mint blog as a resource to help you navigate these monumental money moves and more.
Michael Allegro is a New York-based personal finance writer who specializes in consumer interest, investing, banking products, and travel.