Dividend Reinvestment Plans (DRIP)
A dividend reinvestment program or dividend reinvestment plan (DRIP) is an equity investment option offered directly from the underlying company. The investor does not receive quarterly dividends directly as cash; instead, the investor’s dividends are directly reinvested in the underlying equity. It should be noted that the investor still must pay tax annually on his or her dividend income, whether it is received or reinvested.
This allows the investment return from dividends to be immediately invested for the purpose of price appreciation and compounding, without incurring brokerage fees or waiting to accumulate enough cash for a full share of stock. Some DRIPs are free of charge for participants while others do charge fees and/or proportional commissions.
Although the name implies that reinvesting dividends is the main purpose of these plans, most also allow the enrollee to make additional (or optional) periodic (monthly or quarterly) or occasional cash purchases of company stock, subject to minimums of $10 or more and maximums that often exceed $100,000 per year. These optional cash purchases (or OCPs) may also be commission-free and, like the dividends that are reinvested, need not be in whole-share increments. Most plans allow fractional shares to 3 or 4 decimal places.
DRIPs have become popular means of investment for a wide variety of investors as they enable them to effectively take advantage of dollar cost averaging with income in the form of corporate dividends that the company is paying out. Not only is the investor guaranteed the return of whatever the dividend yield is, but he may also earn whatever the stock appreciates to during his time of ownership. However, he is also subject to whatever the stock may decline to, as well.
A downside of using DRIPs is that the investor must keep track of cost basis for many small purchases of stock, and maintain records of these purchases in paper or electronic form. This assures that the investor can accurately calculate the capital gains tax when any shares are sold, and document cost basis to their government if requested. This record keeping can become burdensome (or costly, if done by an accountant) if the investor participates in more than one DRIP for many years. For example, participating in 15 DRIPs for ten years, with all of the stocks paying quarterly dividends, would result in at least 615 share lots to keep track of—the 15 initial purchases, plus 600 reinvested dividends. Further complications arise if the investor periodically buys or sells shares, or if the company is involved in an event requiring adjustments to cost basis, such as a spinoff or merger.
While the term “DRIP” is usually associated with company-sponsored plans, reinvestment of stock dividends is also available at no cost through some brokerage firms.