Dividend reinvestment has long been one of the great ways to build up a stock or mutual fund portfolio over time, and it works for exchange-traded funds (ETFs), as well.

There are several ways investors can do this, and the best strategy for you will depend upon your risk tolerance, time horizon, and investment objectives.

Key Takeaways

  • By reinvesting the dividends you receive from your investments, you can accumulate more shares and enjoy compound returns over time.
  • Many brokers, as well as publicly traded companies themselves, allow shareholders to enroll in automatic dividend reinvestment plans (DRIPs).
  • Other investors may choose to take their dividends as cash and use those funds to buy additional shares when prices decline.
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Dividend Reinvestment Plan (DRIP) Definition

Dividend Reinvestment Plans (DRIPs)

A simple and straightforward way to reinvest the dividends that you earn from your investments is to set up an automatic dividend reinvestment plan (DRIP), either through your broker or with the issuing fund company itself. This way, all of the dividends that are paid will immediately be used to purchase more shares of the underlying investment without you having to do anything. This can be the best option if you intend to own your funds for an extended period—five years or more.

Some plans and funds will allow for the reinvestment of fractional shares, while others may only allow you to buy whole shares. If your plan falls into the latter category, you may need to occasionally purchase another share or two with the cash that’s paid to you in lieu of fractional shares. This strategy is also a form of dollar-cost averaging because it will automatically buy more shares when the price is down and fewer when it is high.

One key to remember here is that if you set up your DRIP through a brokerage firm, commissions may be charged for each reinvestment. With commissions at online brokers approaching zero, however, this is less of a concern today than it had been in the past.

If you hold your shares directly with a fund company, this service is usually provided for free. In addition, if you are a shareholder of record, you may be able to join that company's DRIP directly.

Reinvesting by Timing the Market

Another strategy some investors use is to have the dividend payments deposited into their brokerage accounts. When enough cash accumulates, the money buys more shares of the dividend-paying item or another security that is trading at a low price. By buying at a market low, the investor achieves a superior cost basis. Opponents of this approach argue that having that much money on the sidelines for that long is counterproductive because it could have generated further dividends if it had been reinvested immediately.

Of course, the outcome of this strategy versus automatic dividend reinvestment depends entirely on how well the investor can time the market using the second approach and the dividend yield of the new securities purchased.

Another version of this strategy is to wait until the market becomes undervalued before reinvesting. Again, the returns from this approach will depend upon the factors listed above.

Buying an Index Fund

You may want to consider using the dividend income to buy another security, such as an S&P 500 Index fund. One of the big disadvantages of most index funds is that they don’t pass dividends through to investors. But if you like index funds and are reaping material dividend income from an ETF portfolio, go ahead and pump that money into your index holdings as a way to simulate the real growth of that index—factoring in dividends at least partially. This can yield handsome returns over time because historical figures show that an index will likely post substantially higher returns when you factor in dividend reinvestment.

You could also use your dividends to buy an investment in another sector. If you have a large portfolio of ETFs that is primarily designed to generate current income, try using some or all of your dividend income to buy something more growth oriented, such as a technology ETF with a solid track record. This can help to balance your portfolio.

Although you don't receive the reinvested dividends as cash, they are still considered taxable income by the IRS (unless they are held in a tax-advantaged account, like a Roth IRA).

Retirement Plan DRIPs

If you want to set up a DRIP that purchases more shares of the company for which you work, the best way to do it may be inside your company 401(k) plan—if your plan allows this and you don’t intend to use any of the proceeds until retirement. The advantage here is that you will not pay income tax on your dividends until you withdraw from the plan, and the net unrealized appreciation rule allows you to peel your shares off from the rest of your plan assets and sell them in a single transaction at retirement.

As long as certain rules are followed, you will receive long-term capital gains treatment on your sale, which will substantially lower your tax bill. You may want to allow your dividends to pay out in cash during the year before your sale, so you don’t have to worry about calculating long- versus short-term gains or losses in the year of sale.

The Bottom Line

Reinvesting your dividends is almost always a good idea if you intend to hold your shares for the long term and don’t need the income now. For more information on dividend reinvestment and how you can make it work for you, consult your stockbroker or financial advisor.

Why Is it a Good Idea to Reinvest Dividends?

Unless you need the cash flows generated from dividends to live, it is often smart to use those proceeds to buy additional shares. This can increase your portfolio's returns over time, both in terms of capital gains as well as additional dividends paid.

How Do I Set Up a Dividend Reinvestment Plan (DRIP)?

Most brokers today allow customers to opt into a DRIP for no additional charge, at which point it will become automatic until it is canceled. For many brokers, you can even pick and choose which holdings you'd like to be on a DRIP and which you would not.

What If the Dividends I Receive Are Worth Less Than a New Share?

Don't worry. DRIPs allow dividends received to purchase fractional shares, meaning you don't need particularly large positions to enroll in one.

How Can I Join a DRIP Directly From a Company in Which I Own Shares?

Many public companies let shareholders enroll directly in a DRIP, which their transfer agents administer. Around 650 companies and 500 closed-end funds currently offer this service.