Dividend Reinvestment Plan Explained
Written by R. A. Stewart
A Dividend Reinvestment Plan, (often called DRIP or DRP) is an automated way to grow your portfolio by reinvesting dividends into the same company instead of receiving cash.
It is the same principle as investing for compounding interest.
Think of it as putting your money to work as soon as it is earned.
How a DRIP works
When a company you own shares in pays a dividend, you have two choices:
- Cash Payout: The money is paid into your brokerage or bank account.
- Reinvestment: The money is used to purchase additional shares (or fractional shares) in the same company.
Most major brokerages and many individual companies offer these plans. In many cases you can “opt-in” through your account settings and the account settings handles the rest.
How it Grows Your Wealth
When you opt into a Dividend Reinvestment plan you are not just owning more shares-its in the snowballing effect over time.
There are three key benefits.
- The Power of Compounding
Any dividends which are reinvested into the company will earn dividends during the next cycle which can accelerate your holdings in the long-term. An example is that you own 100 shares in a company. They pay a dividend and the dividend is converted into shares. You now own 102 shares.
- Dollar Cost Averaging
DRIPS purchase shares at regular intervals and this means:
(a) When the market is down you purchase more shares-its
(b) When the market is up you purchase fewer shares.
It all balances out in a year which mean that you are practising dollar-cost averaging.
- Reduced Fees and Discounts
There are reduced fees because you are purchasing more shares without the need for the normal transaction fees.
It will pay to check on the conditions of the brokerage firm or the online platform where you have invested your money because not all of them are the same.
Important considerations
DRIPS are a powerful tool for wealth-building, there are some things to consider.
Taxation: Dividends reinvested are still considered taxable income of the year that they are received even if you did not receive them in the form of cash.
Stock Imbalance: If a company pays a high DRIP then you could end up with a greater percentage of share in that company in your portfolio.
Income needs: If you may need the money for living expenses then taking your dividends in the form of extra shares may be impractical.
Summary
Feature Benefit to you
Automation “Invest and forget” helps to build discipline
Fractional Shares You own more shares even if it is a fraction of a share.
Compound Interest You accelerate your savings through compounding.
Why companies offer a DRIP
DRIPS are one way companies can generate more cash. Companies have a good idea of how much money they are likely to generate with DRIPS so it is a cost-effective way of raising capital. Reinvesting future dividends into the company means that an investor has confidence in the company’s prospects.
About this article
The contents of this article is based on the writer’s own opinion and experience and may not be applicable to your personal circumstances, therefore discretion is advised. You may use this article as content for your blog/website, or ebook.
Read my other articles on www.robertastewart.com
