Before you enroll in a DRIP, it’s important to learn how DRIPs work, the benefits they provide and the drawbacks, and how you can enroll in a DRIP.
What Are DRIPs?
DRIPs are programs that automatically invest into more shares any cash dividends you receive. You must elect to enroll in a DRIP; these plans are not compulsory. Depending on your broker, you could have multiple investment options that offer DRIP. For example, TD Ameritrade has DRIPs for stocks, ETFs, mutual funds, and American depository receipts.
How Does DRIP Investing Work?
For a basic example of how DRIPs work, assume you have 500 shares of a company that pays out a $1 per share dividend. You’re enrolled in a DRIP program through your brokerage firm. When the company pays out its dividends, you’ll receive $500. Suppose that when you receive the dividend the stock is trading for $25 per share. Instead of receiving the $500 cash, you’d receive an additional 20 shares of the stock instead.
Fractional Shares
Fractional shares are just what they sound like: They are fractions of a whole share. So, it’s possible to own 1.65 shares of a stock, for example, instead of one or two shares. What if the stock was $26 in our example above? Five hundred dollars would purchase an uneven 19.23 shares. You would receive 19 shares worth $494, but different brokerage firms may treat the .23 fractional share differently. In some cases, you could buy the fractional share and would receive 19.23 shares.
Pros and Cons of DRIP Investing
Pros Explained:
Dollar-cost averaging: By automatically reinvesting dividends you will inherently practice dollar-cost averaging. Dollar-cost averaging involves the recurring purchase of an investment, rather than investing in one lump sum. Purchasing additional shares at regular intervals can help lower your total average purchase price. Immediate reinvestment: Because the dividends are automatically reinvested into additional shares, DRIPs can reduce the chance that you leave the cash sitting uninvested if you forget to manually do it. Cash left uninvested in an account can reduce returns over time. Lower commissions: If you have a DRIP set up through a brokerage firm, the firm may eliminate the commission on most reinvested dividends. This will mean more of your cash is invested into additional shares. However, not all brokerage firms provide DRIPs without commission, so make sure to check yours.
Cons Explained
Taxation: If you participate in a DRIP in a taxable account, be aware that you will still have to pay up to 20% in taxes on your reinvested dividends. The particular concern here is to make sure that you have the cash to actually pay the tax when it’s due. Otherwise, you may be forced to sell some of your shares to get the cash anyway. Lack of diversification: If you set up a DRIP plan for one stock, you will potentially accumulate a significant amount of that particular stock over time, reduce your diversification, and leave you with more risk than is necessary. Make sure to periodically check your portfolio and rebalance.
How to Set Up a DRIP
Normally, you can enroll in a DRIP through your brokerage firm when you purchase an investment by logging into your online account and selecting the option to have dividends reinvested. Or, you can call your advisor if you work with one and have them walk you through it.
