Investors favor stocks over traditional safe havens like savings accounts and bonds due to the former’s limited growth potential. If you buy stock in a corporation, you effectively become a part owner. When a company is successful, it can afford to distribute a portion of its earnings to its shareholders in the form of dividends.
Dividends provide a way for investors to convert their portfolio into a stream of income that can be used to fund everyday costs of living, but not all investors seek such a payout.
Reinvesting gains is a popular strategy for those who want to see their portfolios expand. Investors may find assistance in doing so through dividend reinvestment programs (DRIPs).
Dividend reinvestment strategies are based on a straightforward concept. Oftentimes, stockholders of a company may receive a monetary dividend payment from the business on a regular basis. The dividends you receive from some firms can be reinvested to purchase more of the company’s stock.
You can create a DRIP for any stock or mutual fund that pays shareholders dividends by having your brokerage firm automatically reinvest the dividends you receive, even if the issuing company does not offer a DRIP.
What Is a Dividend Reinvestment Program?
One way for shareholders to gradually increase their stake in a firm is through the use of a dividend reinvestment scheme. They have widespread acclaim among shareholders of large, dividend-paying blue chips.
Investors usually receive cash in exchange for dividends paid by companies. Investor who participates in a Dividend Reinvestment Plan (DRIP) has their dividends reinvested in the form of new shares of the firm that is providing the dividend.
Each dividend payment is used to purchase further stock for the portfolio. Investing more money initially pays you in larger dividends later on. A modest initial investment in the stock of a single firm might turn into a substantial sum over time.
Participating in a DRIP has several advantages, and some companies even sweeten the pot by providing registrants with incentives like discounted shares. One percent saving here and there can build up to significant savings in the long run.
Typical Dividend Reinvestment Plan
Let’s say you invest $10,000 in shares of Company XYZ and join their dividend reinvestment program. Every three months, shareholders can expect a dividend payment of $0.50.
You will get $5 in dividends the first time they are distributed. You have a total of 10.05 shares now instead of 10. If you reinvest your dividends at $100 each, you will have purchased 0.05 shares.
You’ve just received your $5.025 dividend check for the year’s second dividend payment. Your dividend reinvestment of $100 will allow you to purchase an additional $50.25 in shares, bringing your total number of shares owned up to 10.10025.
To increase your interest in the company from its current level of 10.15075 shares, you can reinvest the next dividend payment of $5.050125, which will give you 0.0505 shares. Additional shares worth 0.0507 can be purchased with the fourth dividend payment of $5.075.
To put it another way, if you buy 10 shares today, you’ll own 10.20145 shares by the end of the year. Your dividend income and stock purchases will both increase over time, allowing you to rapidly expand your holdings.
An Actual Case Study of a Dividend Reinvestment Plan
The Dividend Reinvestment Plan (DRIP) that 3M provides is a real-world example of such a plan. 3M is a Fortune 500 firm that produces over 60,000 items with widespread consumer adoption. It’s one of the rare stocks that has managed to raise its dividend payment for the past 25 years straight, making it a member of the exclusive club known as the dividend aristocrats.
In order to buy 3M stock through their DRIP, a brokerage account is not required. You can reinvest all or part of your dividend income from 3M if you possess 3M shares, and anyone who owns 3M stock can do so.
Participating in 3M’s DRIP is a simple way to increase your investment, and while it does not come with any rewards like discounted goods, it still is worth considering. In addition to Disney and Coca-Cola, many more firms also offer DRIPs, allowing you to invest in your favorite companies through them.
Motives for Participating in a Dividend Reinvestment Program
Investors participate in dividend reinvestment programs for a variety of reasons:
1. DRIPs Average the Security’s Cost Over a Year
Investors often worry that they will have to acquire shares at a high price only to see them decline in value. A DRIP allows you to invest a modest amount of money regularly throughout the year. This method of dollar-cost averaging, in which shares are purchased at varying prices throughout the year, can help mitigate the impact of price changes.
2. You Can Purchase Shares at a Discount
When purchasing shares with dividends, buyers can get a discount through some direct DRIP programs offered by firms. In addition to purchases made using dividends, cash on hand can be used to buy stocks at a discount.
Since small investors typically don’t trade huge volumes of stock, dividend reinvestment programs are a fantastic resource for them.
3. The Possibility of Quicker Investment Growth
The force of compound interest cannot be understated. For example, if your interest rate is 10% and you invest $100, you will receive $10 after a year. In two years, your interest earnings will total $21. By the end of the third year, you will have accumulated $33.10.
In 20 years, you will have $672.75, with interest contributing $572.75. Adding a little bit more now can make a huge difference in the future. In the previous example, if the rate of return was lowered from 10% to 7%, the total amount in the account would be reduced from $388.97 to $386.97, of which $286.97 would be interesting.
In the long run, that extra 3% practically doubles your earnings after 20 years of compounding. The dividend yield of the Standard & Poor’s 500 Index (SPX), which tracks the performance of 500 of the top corporations in the United States, is 1.8% as of this writing, suggesting that reinvesting dividends can greatly boost gains.
Increasing gains via dividend reinvestment is possible because many companies provide even higher dividend yields.
Disadvantages of Dividend Reinvestment Plans
You should think about these issues before deciding to use a DRIP.
1. A Loss of Flexibility
With a DRIP, your dividends will be reinvested directly back into the stock or mutual fund that originally paid them out. Investing more of your money in companies that offer larger dividends can lead to an unbalanced portfolio over time.
When dividends are paid out in cash, investors have more flexibility in allocating those funds to investments of their choosing. You’ll have greater leeway in deciding which new securities or asset classes to include in your portfolio, and you’ll be better able to maintain a healthy mix of assets.
2. Tax Monitoring
For reasons of paying capital gains tax, it’s important to remember how much you paid for an investment. The amount you originally paid for security is known as its cost basis. The cost basis of your stock portfolio should be updated if you get a dividend and reinvest it in the company, as this will result in the purchase of extra shares or fractional shares at a different price.
If you invest in a DRIP for a company that distributes dividends on a quarterly basis, you will buy shares at least four times a year. In a few years, you could have a dozen different cost bases for the shares you hold. In order to calculate your tax liability upon the sale of these shares, it can be difficult to keep track of which shares you are selling.
3. Dividend Taxes
Dividends have immediate tax ramifications, on top of the added complexity, they bring to capital gains taxes and cost-basis tracking. Dividends are considered taxable income and must be reported on your tax return.
If dividends are paid out in cash, you can invest some of the money and utilize the rest to cover your tax bill. If you participate in a dividend reinvestment plan (DRIP), all of your dividends will be used to buy more shares, and you will need to find another way to cover the tax bill.
The Starting Point
Here are some suggestions for getting started with DRIP investing.
To begin with a DRIP, you must first find out if the firm in which you are interested in investing provides such an option to its shareholders. The dividends you receive from many firms also come with the option of having them automatically reinvested in the company through a dividend reinvestment plan (DRIP).
In most cases, you will need to request an enrollment form from the corporation if you already possess shares of stock in the company. The company’s website may serve as a resource for locating this form.
When buying shares through a broker, it’s possible that the broker’s name will appear on the shares. If this is the case, you’ll need to request a transfer of the shares into your own name.
Finding a DRIP without any administration costs is another important consideration. Though most firms don’t, some do; and though the fees are often little, they can be a significant impact on profits if you only have a modest holding of shares and hence receive a modest dividend.
You can also set up a DRIP with your broker’s direct assistance. Your dividends can be automatically reinvested at several brokerages. For businesses that don’t have their own DRIP program or for investors in dividend-paying mutual funds, this is a great option.
This can save you money on the DRIP costs charged by the issuing business if your brokerage doesn’t charge commissions. However, you may lose out on some perks, like cheaper stock options, by not joining.
The Reinvesting Dividends and Taxes
If you already own the stock and have chosen to have dividends automatically reinvested, they will do so until you instruct the firm or your brokerage differently, the company terminates its dividend reinvestment program, or the investment no longer pays a dividend.
A 1099-DIV form will be sent to you annually if the sum of your dividends is more than $10. There is a chance that you will have to pay taxes on the dividend even if you did not get it in cash.
DRIPs Are Excellent Gifts
A gift of DRIP-enabled shares is an excellent way to pique a young investor’s curiosity about the stock market and the world of money. Keep in mind this suggestion:
Coca-Cola, Disney, and McDonald’s are just a few of the well-known companies that offer consistent dividends. Even if they don’t understand the value of saving money, most kids and teens have certain preferences in terms of the brands and items they like. Young investors may be swayed to consider the stock market if they are told they can buy a piece of their favorite company.
The dividend check or electronic deposit might be shown to the youngster when it arrives. Even if you plan to reinvest the dividend for them, you can make it more tangible by handing them the cash equivalent of the dividend.
The dividend will increase quarterly in proportion to the number of shares held. The effect of compounding may now be fully appreciated by the young learner. A little stake in a significant firm and a deeper understanding of the impact of reinvested dividends will be theirs by the time they reach adulthood.
Creating a dividend reinvestment plan is something anyone can do, but it will take some time and energy. Make sure the company you invest with provides a DRIP and does not impose any costs before making your final decision.
To acquire shares of your favorite firm, you may need to employ a direct buy plan or have the stock certificate transferred into your name.
Then, with the help of a dividend reinvestment scheme, you may start saving a ton of cash and enjoying the compounding growth of your investments with less effort.