Analyzing The Best Retirement Plans And Investment Options: Direct Reinvestment Plans (DRIPS)
- What they are: Plans offered by corporations that allow you to reinvest cash dividends by purchasing additional shares or factional shares on the dividend payment date.
- Pros: Convenient means of reinvesting; often commission-free; shares may be purchased at a discount.
- Cons: You owe taxes on cash dividends even though you never receive the cash.
- How to invest: Directly through a participating company or its transfer agent.
A dividend reinvestment plan, or DRIP, is a plan offered by a company that allows you to automatically reinvest any cash dividends by purchasing additional shares or fractional shares on the dividend payment date. Instead of receiving your quarterly dividend check, the entity managing the DRIP (which could be the company, a transfer agent or a brokerage firm) puts the money, on your behalf, directly towards the purchase of additional shares. Many DRIPs allow you to start with a very small number of shares or low dollar amount (as little as one share or perhaps $10) and support fractional shares. For many investors, DRIPs offer a convenient method of reinvesting, and they are ideal for investors who do not need cash flow from dividends and who want to build their investment over the long term.
Many DRIPs allow you to purchase the additional shares commission-free and even at a discount from the current share price. DRIPs that are operated by the company itself, for example, are commission-free since no broker is involved. Certain DRIPs extend the offer to shareholders to purchase additional shares in cash, directly from the company, at a discount ranging between 1 and 10%. Because of the discount and commission-free structure, the cost basis of shares acquired can be significantly lower than if bought outside of a DRIP.
It is possible to create synthetic DRIPs through your brokerage account. Certain brokers, including Fidelity, Schwab and TD Ameritrade, offer to reinvest any dividends at no additional cost (outside of regular commissions). This can be an advantage if you want to reinvest your dividends from a company that does not offer a dividend reinvestment plan. Currently, about 1,300 companies offer DRIPs.
With DRIPs, the primary disadvantage to shareholders is that they must pay taxes on the cash dividends reinvested in the company even though they never receive any cash. This holds true whether your dividends are reinvested directly through the company or if you set up a synthetic DRIP with a broker. Another concern with DRIP investing is that it often turns out to be a bit of a set-it-and-forget-it strategy. While this can be a good thing, it is not necessarily so if dividends have been slashed and share prices have dropped. As with any investment, it is important to periodically review and assess the performance of a DRIP to ensure it is meeting your investing goals.
If you sell your shares that are held in a DRIP, you must calculate your cost basis: the purchase price plus any commissions and fees, taking into account any stock splits and other adjustments. Determining the cost basis for shares that have been held for a number of years with dividend reinvestment can be tricky; however, new laws require that this information be furnished to investors by brokers that offer DRIPs (this does not apply to investments you purchased before the laws went into effect on January 1, 2012). Analyzing The Best Retirement Plans And Investment Options: 401(k)s And Company Plans