What is Dividend Reinvestment Plan (DRIP)?

DRIP investing is an easy way to reinvest your dividends into your dividend stocks in a way that grows the number of shares you have over long periods of time. DRIP stands for “dividend reinvestment plan” or sometimes “direct investment plan”. Many companies offer their shareholders the ability to convert their dividends into additional shares of stock directly without the use of a brokerage firm.

What is a Dividend Reinvestment Plan?

DRIP

There are three primary ways to own shares in a company:

  • Purchase shares through a brokerage firm
  • Purchase shares in a mutual fund that invests in shares of that company (and many other companies)
  • Purchase shares directly from the company

When you invest through a brokerage firm or mutual fund, you pay an assortment of fees to do so. It might be something as small as a $5 or $10 trade charge at an online discount brokerage or something more complicated like a sales load or expense ratio on a mutual fund. Either way the investment is costing you money in order to hold the shares of the company.

With a Dividend Reinvestment Plan (DRIP) you can bypass these charges by buying shares directly from the company with the dividends earned from your current shares. Instead of receiving money in your brokerage account for the amount of the dividends, that dividend payment is used to buy new shares at the current share price. (If a full share cannot be purchased, many DRIPs will let you buy fractional shares.)

For example, if you held $1,000 worth of stock currently priced at $45 per share, and those shares paid you $30 in dividends, a DRIP program would reinvest those dollars and purchase 0.75 shares of the stock to add to your total number of shares owned. If you held the shares in a brokerage account and did not use a DRIP plan, your brokerage account would simply have $30 in cash sitting in it.

Many good brokerage firms will also simulate DRIP and let you reinvest dividends without having to pay trading fee. However, be sure to check with your broker to see if they offer this feature and if there are any requirement that you have to meet.

Important Considerations

DRIP Investing and Taxes

How does DRIP investing impact your taxes? This is where things can be a little bit more complicated. If you are given a cash dividend payment that is placed into your brokerage account, you know you need to pay taxes on the amount of the dividend. The amount of tax you pay on a qualified dividend depends on your tax rate — if your tax rate is more than 25% then you pay 15% on dividends, otherwise you pay 0% tax on qualified dividends.

With DRIP investing you never see the dividend payment hit your brokerage account. The money is directly turned into shares and fractional shares. If you don’t keep good records of how much the dividend was, you can be surprised by a tax bill at the end of the year. You won’t be able to pay the tax out of the money generated by the dividend, either.

Cost Basis Impact by DRIP

A second impact of using DRIP investing is you greatly increase the number of transactions included in the purchase of shares. You might invest money only a few times per year when you save enough money to buy shares. When you are buying big chunks of shares it is easy to see what your cost basis is on the shares. With DRIP investing you are adding more transactions based on the number of dividend payments the company sends out. Additionally those reinvested dividends will be in fractional shares. You must keep excellent records to avoid paying too much tax when you eventually sell the shares of the stock.

Should You Use a DRIP for Your Dividends?

Using DRIP plans to reinvest your dividends can make the acquisition of additional shares easy. You don’t have to login to your brokerage account and decide how many shares to buy or make sure you have enough money to pay a trade fee plus whole shares. A DRIP program lets you slowly grow your share balance over time without even investing any more money.

However, you must keep track of how much income tax you will owe on the dividends that are paid out to you as well as your cost basis of your new shares. You may also not want to reinvest all of the dividend back into the company. If you are relying on dividend income to pay for your daily expenses, you want the cash, not additional shares. But if this type of program works for your investment goals, it can be an easy way to reinvest while avoiding trading charges.



Author

By , on Apr 6, 2013
Pinyo Pinyo is the editor of Moolanomy Personal Finance and an entrepreneur with over 20 years of business experience. He combines his passion technology and finance to bring you informative personal finance articles to help you improve your finances.

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{One Comment}

  1. DRIP is the acronym for Dividend Re-Investment Plan. This is where investors can elect to receive their dividends in the form of shares instead of being paid in cash. Most large companies will offer this facility.

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