A Dividend Reinvestment Plan, or DRIP, is an easy way to buy more shares using the dividends you received from your stocks. With this plan, you grow the number of shares you have over long periods of time. Many companies offer their shareholders the ability to convert dividends into additional shares of stock directly without the use of a brokerage firm. Many brokers also provide the ability to reinvest dividends with no transaction fee.
What is a Dividend Reinvestment Plan?
Although some companies allow you to purchase shares directly from them and participate in DRIP, I do not recommend this option since it spread your money all over the place and can become an administrative burden for you.
A better way to participate in DRIP is to find a brokerage firm that allows you to reinvest dividends automatically at no charge. Currently, I am using M1 Finance, which automatically reinvests dividends whenever the cash balance exceeds $10. As a bonus, M1 Finance does not reinvest in the company that paid the dividend but reinvest in your most underweighted stocks or ETFs based on your pre-defined asset allocation.
Another broker that I use, TD Ameritrade, also offers free DRIP:
We offer DRIP, free of charge, on most exchange-listed and NASDAQ stocks, ETFs, mutual funds, and ADRs. The stock and ETF dividend reinvestment plan (DRIP) allows you to reinvest your cash dividends by purchasing additional shares or fractional shares.
Whatever you do, avoid brokers that do not provide free DRIP. Without free DRIP, you will have cash sitting idle in your investment account, and you will have to pay a transaction fee to buy shares.
For example, if you held $1,000 worth of stock currently priced at $50 per share, and those shares paid you $30 in dividends, a DRIP program would reinvest those dollars and purchase 0.6 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 idle cash.
DRIP Investing and Taxes
How does DRIP impact your taxes?
This is where things can be a little bit more complicated. For your retirement accounts like Roth IRA and Traditional IRA, you don’t have to pay any taxes.
For your taxable account, you have to pay taxes on the amount of the dividend received each year. There are two types of dividends. For an ordinary dividend, you pay tax at your regular tax rate. For a qualified dividend, you pay tax at your long-term capital gains tax rate — e.g., if your tax rate is more than 12% then you pay 15% on dividends; otherwise, you pay 0% tax on qualified dividends.
Cost Basis Impact by DRIP
A second impact of using DRIP investing is you significantly 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 the cost basis of your new shares. You may also not want to reinvest all of the dividends 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.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.