When companies pay dividends to their investors, the receiver decides what happens to the money. Some choose to reinvest their dividends, but some choose to have the money paid out. Many investors use a dividend reinvestment plan (DRIP) to invest the money they receive in more shares of that company.
What is a DRIP?
A dividend is a distribution of profits by a company paid to shareholders. It is usually paid when a company makes a profit or surplus to satisfy shareholders. Also, it incentivizes investors to hold or invest more funds in the stock.
DRIPs give investors the ability to reinvest their dividends to buy more shares of the company. These plans can be set up directly with the company or through a brokerage account. Investors can accumulate their gains with the reinvestment program and reduce risk with the dollar-to-dollar averaging.
For example, an investor holding 100 shares of a stock may choose to reinvest the dividends. The company pays a quarterly dividend of $0.10 per share and its stock price is currently $10. Therefore, owning 100 shares means that the investor will receive a dividend of $10.
A DRIP will use that $10 to buy more shares. As a result, the investor receives an additional share, increasing the position and the dividend on the next payout.
This has been a popular investment strategy because investors can accumulate additional shares at a constant rate while averaging the entry price.
According to CFRA Research, reinvested dividends have contributed 33% of the total return of the S&P 500 since 1945. As a result, dividends can improve your performance without you having to go online and invest more money.
You set up a DRIP through a broker, usually online. Once selected, a feature in your account provides various options on how to use a DRIP.
Investors can automatically enroll all current and future stocks and funds for an automated experience, as any stock or fund that enters your portfolio can be automatically added to the program. In addition, when a company in your portfolio chooses to pay a dividend, it will be automatically reinvested.
Another option is to list all current stocks and funds in a portfolio. However, this will only reinvest the dividends in your portfolio at that time. All new stocks added to the portfolio over time must be added manually. Therefore, investors need to consider whether they want to enjoy the convenience of automation or retain some control over their dividends.
Investors can also take full control of their dividends and select individual stocks and funds to automate. This process will be less convenient but allows the investor to take more initiative and have the last word.
Finally, individuals can go directly to the company to buy its shares and reinvest its dividends. This plan has additional advantages and disadvantages.
Can you set up a DRIP for fractional shares?
Investors can use a DRIP for fractional shares. A DRIP is not limited to whole stocks, giving investors more options to use this plan for various stocks.
A DRIP for fractional shares occurs when the dividend payment is less than the total cost of the share. Therefore, the investor will receive fractional shares accordingly.
For example, if the company’s stock price is $50 and the investor receives a dividend of $10, it will be reinvested as a fractional share. The investor will receive one-fifth of a share of its dividends. Thus, investing through the DRIP scheme is accessible to everyone, whether it is a large investment or a small investment.
Using a DRIP for fractional shares is common for more expensive stocks. For example, a stock like Apple has a high price and would require a large investment to hedge an entire stock. Owning 20 shares of Apple will result in a small dividend payment that can only be reinvested in fractional shares.
The advantages of a DRIP
An investment plan such as a DRIP is popular and is used by many investors and companies. Reinvesting your dividends can significantly increase long-term profits. But what are some of the significant benefits you can get?
Easy setup: Setting up a dividend reinvestment plan can be simple, and once completed, it is an automatic system. This can be done either through your broker or with the company itself. There’s minimal hassle, and once it’s installed, it can be left alone.
Average purchase: The cost averaging technique is extremely beneficial. It intends to average an investor’s position as the stock goes up and down. You are not entering at an absolute price, but rather you are entering at different levels over the long term. As a result, it reduces risk because you are not buying during a peak or trough.
Lower cost: Many DRIP programs are popular due to the minimal costs involved. Often, you won’t see any commissions or brokerage fees, ensuring that investors can use their plan for free.
Meanwhile, the use of a DRIP through the company means that many investors are being offered their shares at a discount rate of between 3% and 5%.
Steady growth: Investing your dividends over a long period of time is one way to achieve steady growth. Investors buy more shares with each payment, which will increase their returns if the company continues to pay dividends.
Compound returns can be a big part of it over time, which has been evident with many companies and indices in the past. It’s a great strategy for trying to achieve steady growth over the long term, and the consumer can undo it at any time.
Security: Companies offering DRIP programs have their dividends reinvested in the company. Therefore, companies can reinvest the capital to grow their business.
Shareholders are likely to remain loyal to the company and unlikely to sell in times of uncertainty. Over time, the investment may be more immune to significant declines in its share price. Investors are in it for the long term and each party can benefit.
Time saving : A DRIP is very convenient and can save the investor a lot of time. Not only is it quick and simple to set up, but once complete, it can be left alone. The broker or company takes care of the rest of the management.
Considerations of a DRIP
Using a DRIP is extremely beneficial and investors can see higher returns over the long term. However, investing in the stock market can tip the scales in your favor, but there is always a degree of risk involved. In addition, companies that pay dividends can decide to stop paying them at any time.
Here are some key considerations of a DRIP.
Taxes: One thing to note is that cash dividends received and reinvested are still considered taxable income by the IRS. Therefore, it should be reported to them and you may need to hire a tax professional to analyze your current situation.
Risk: Every investment involves a certain degree of risk, and this risk increases as you buy more shares. A significant decline in the share price could occur. Therefore, if you continually reinvest in a business, it must be in a company you trust.
Costs: Although there are limited fees and expenses associated with using a DRIP, dividend reinvestment is not an option for everyone. Many individuals need the money they receive from dividends to cover day-to-day expenses. Therefore, this option is only available to those who do not need the funds they receive.
Flexibility: If you are working directly with the company to use DRIPs, one thing to consider is the flexibility of buying and selling shares. You may not be able to buy and sell as quickly as possible through a regular brokerage account.
In a regular account, you can react more quickly to a sudden rise or fall in the market. On the downside, you’ll likely have less direct control when dealing with the company because you have to sell the shares back to the company.
You cannot sell the shares on the open market and a request to sell must be made to the company.
A DRIP is offered directly by many brokers and companies. However, as several brokers are available, it can be difficult to choose the best one. Here is information and reviews on some of the biggest brokers that offer DRIPs to investors.
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Frequently Asked Questions
questions and answers
How to buy DRIP shares?
You can buy DRIP shares by automatically signing up for a DRIP or manually entering it each time. It can be a simple process and is an option for all investors. Dividend reinvestment through a brokerage account can be done through account settings. Additionally, investors can approach the company directly to buy shares and use its DRIP plans.
Do you have to pay tax on RRDs?
Yes, investors must pay tax on DRIPs. Although investors using a DRIP plan do not receive the money from its dividends because they are automatically reinvested, they are subject to taxes on those dividends paid, which are considered income.