Understanding Dividend Reinvestment Plans (DRIPs)

A Dividend Reinvestment Plan or “DRIP” is a plan offered by a company that enables investors to purchase additional shares (or fractional shares) by reinvesting their cash dividends on the date of payment. DRIPs offer investors a cost-effective way to make good use of their stock dividends as most DRIPs allow for these dividend reinvestments with little no fee. In fact, many DRIPs offer investors the opportunity to purchase stock at a discounted price. For many investors, DRIPs offer a powerful wealth-building tool In fact, according to some estimates, as much as 65% of U.S. stock gains have come from reinvestment of dividends.

Different Types of DRIPs

Different companies may offer their DRIPs in different ways. For example, Some DRIPs purchase the stock directly from the company, while others make the purchase on the open market, in which case you will incur brokerage fees. Some plans may deduct a service fee from your dividends before reinvesting. Some DRIPs allow “optional purchases” under which plan participants may acquire additional shares with a cash payment.

Before signing on, investors should receive a prospectus that describes the features of that plan.

Dividend Reinvestment Plans and Dollar Cost Averaging

Dollar Cost Averaging is an investment approach under which the investor buys a fixed dollar amount of a particular investment on a regular basis, regardless of the current share price. With dollar cost averaging, more shares are purchased when prices are low, and fewer shares when prices have risen. One of the reasons that DRIPs have become so popular is that they offer investors a convenient and cost-effective mechanism to implement dollar cost averaging.

One downside of using a dividend reinvestment plan is in the investor having to keep track of the cost basis of these many small purchases for tax purposes.

The Tax Consequences of DRIPs

Dividends are taxed as ordinary income, regardless of whether they are re-invested in stock. The plan administrator sends a year-end statement to show the dividends paid.

DRIP investors should keep complete records in order to know their cost basis for when they sell.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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