The DRIP (Dividend Reinvestment Plan): An Introduction
A dividend reinvestment plan (DRIP) is a program that helps investors buy more company stock shares by reinvesting the cash they earn from its dividend payments. DRIPs help investors take advantage of compounding returns and potentially purchase company stock at discounted prices. Many dividend-paying companies offer DRIPs.
DRIPs also benefit from dollar-cost averaging. Dollar-cost averaging spreads investments over periodic intervals, rather than investing in one lump-sum. This strategy reduces short-term volatility. These plans enable investors to dollar-cost average: they buy additional shares at regular intervals that correlate with dividend payment dates.
There are a few different types of DRIP programs, including company-operated DRIPs, third-party DRIPs, brokerage DRIPs, and DIY DRIPs.
Company-operated DRIPs are the most common DRIP programs. A publicly traded company sets up a formal DRIP program for existing shareholders. Several large companies operate DRIPs, including Boeing, Coca-Cola, Costco, and IBM.
The company itself manages these DRIPs directly. They allow existing shareholders to reinvest their dividends and buy new stock directly from the company. Shareholders can avoid using a brokerage firm as intermediary.
Third-party DRIPs are popular because companies can outsource DRIP programs management to third parties, like a transfer agent. Major transfer agency companies include Computershare Limited, Continental Stock Transfer & Trust Company, and Equiniti Trust Company. Third-party DRIPs may charge fees for buying new shares.
Brokerage companies may establish an automatic reinvestment arrangement. These DRIPs allow investors to choose dividend-generating stocks. This means investors can invest in and use DRIPs for stocks of multiple companies, and it facilitates portfolio diversification.
The brokerage deposits the dividend into the investor’s brokerage account. The brokerage firm will automatically reinvest the cash earned into new shares of the selected stocks. Since brokerage firms or robs-advisors coordinate coordinated these DRIPS, they are a hassle-free way to reinvest dividends.
As an example, let’s assume Jane received a total cash dividend of $20,000 from a company. Since Jane participates in the company’s DRIP program, she can reinvest the entire $20,000 she earned in cash dividends to buy additional shares. As a DRIP participant, Jane buys additional shares at a 15% discount. On the dividend payment date, the market price of the company’s stock is $60 per share. This means that Jane can buy additional shares at only $51 per share.
Tax Benefits of DRIP Investing
Dividends are taxable income. This includes their cash dividends, despite the direct reinvestment.
The Internal Revenue Service (IRS) requires investors to use a Form 1099-DIV to report dividend income to . Any individual who makes more than $10 in dividend income must complete a 1099-DIV. There are two categories of dividend income: qualified and non-qualified dividends. Qualified dividends are taxed at the long-term capital gains tax rate, whereas non-qualified dividends are taxed at the ordinary income tax rate.
Most dividends from U.S. publicly-traded companies are considered qualified dividends. Examples of non-qualified dividends include those from real estate investment trusts (REITs), employee stock options, and master limited partnerships (MLPs).
Direct Stock Purchase Plan (DSPP)
Direct stock purchase plans (DSPPs) are sometimes thought of as DRIPs, but they are distinct. DSPPs can offer dividend reinvestment plans, but their use expands beyond that. In DSPPs, investors can purchase shares directly from a company through an optional cash purchase. In other words, unlike a DRIP, it is not mandatory to use cash dividends to purchase additional shares.
Investors usually make monthly cash deposits into a DSPP. The plan will then apply the deposited funds toward buying new shares of the company’s stock. Like DRIPs, shares can often be purchased at a discounted rate. DSPPs generally have low fees associated with them, making them a seamless way to accumulate company shares. They’re also an accessible way for less experienced investors to generate investment return over time.