What are DRIP Plans?
DRIPs are programs that automatically reinvest dividends into more shares of stock using any cash dividends you receive from the investments you own. You must choose to enroll in a DRIP; these plans are not mandatory. The investment options provided by a DRIP plan depend on your broker. For example, TD Ameritrade offers DRIP plans for stocks, ETFs, mutual funds, and American Depositary Receipts.
How Does DRIP Investment Work?
Let’s take a simple example of how DRIPs work. Suppose you own 500 shares of a company that pays a cash dividend of $1 per share. You are enrolled in a DRIP program through your broker. When the company pays dividends, you will receive $500.
Suppose the stock is trading at $25 per share. Instead of receiving $500 cash, you will receive 20 additional shares of stock instead.
Fractional Shares
Fractional shares are just portions of a whole share. So, it’s possible to own 1.65 shares of a particular stock instead of one or two shares.
What if the stock price was $26 in the example above? You would buy $500 worth of stock which would equal 19.23 shares. You would receive 19 shares worth $494 but different brokerage firms may handle the decimal portion of 0.23 differently. In some cases, you can purchase the decimal portion of the share and receive 19.23 shares. Fractional shares are not available in all brokerage firms. The excess cash from purchasing whole shares may be treated as cash and added to the investor’s account.
Advantages and Disadvantages of DRIP Investment
Advantages:
– Dollar-cost averaging: By automatically reinvesting dividends, you will naturally be practicing a dollar-cost averaging strategy. The dollar-cost averaging strategy involves buying the investment repeatedly, instead of investing a lump sum all at once. Regularly purchasing additional shares can help lower your overall average purchase price.
– Instant reinvestment: Because dividends are automatically reinvested into additional shares, DRIPs can reduce the likelihood of leaving cash sitting uninvested if you forget to do so manually. Leaving cash in the account without investment can reduce returns over time.
– Low commissions: If you have a DRIP set up through the brokerage firm, the commission for all reinvested dividends may be free. This lower commission will mean that more of your cash will be invested in additional shares. However, not all brokerage firms offer commission-free DRIPs, so make sure to check with your brokerage.
Disadvantages:
– Taxes: If you participate in a DRIP in a taxable account, you may have to pay up to 20% tax on the dividends that were reinvested. The key issue here is ensuring that you have enough cash set aside to pay taxes when they are due. Otherwise, you may be forced to sell some shares to get cash anyway.
– Lack of diversification: If you set up a DRIP for a single stock, you may accumulate a large amount of that stock over time, which reduces your diversification and leaves you with more available risk. Be sure to review your portfolio periodically and rebalance.
How to Set Up a DRIP
You can usually enroll in a DRIP through your broker when you purchase an investment by logging into your online account and selecting the option to reinvest dividends. Alternatively, you can contact your financial advisor if you are working with one, and they can guide you through the process.
Note: Some companies offer their own DRIP programs as well. To enroll in a DRIP program with an issuing company, you will need to contact them directly to sign up. You can find the relevant contact information through the company’s investor relations.
Source:
https://www.thebalancemoney.com/your-guide-to-drip-investing-5116199
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