If you want to boost your investment returns over time, dividend reinvestment is an attractive strategy that allows you to do just that. With dividend reinvestment, long-term investors can use the power of compound interest to purchase additional shares of stock through reinvesting dividends. Over time, investors can benefit from increased ownership, growth from the stocks, and reduced market risk through dollar-cost averaging.
Dividend stocks are a solid option for investors looking for benefits such as steady returns, retirement income, or a buffer against market volatility. During rough patches in the stock market, dividend stocks have been great tools for combatting economic downturns like recessions or inflation.
All of this is possible through dividend reinvestment plans (DRIPs). But, what exactly is a DRIP, and how can it boost your investments? We will break down what a DRIP is, its benefits and disadvantages, and ways you can get started.
Key Takeaways
- Dividend reinvestment plans (DRIPs) are a way for long-term investors to steadily grow their initial investment through reinvesting dividend payments back into the underlying stock or fund.
- There are three main ways to enroll in a DRIP. You can sign up directly with a company, through a transfer agent, or your brokerage.
- Dividend investors benefit from flexible DRIPs and the power of compound interest.
What is Dividend Reinvestment?
Before we go into the details of dividend reinvestment, we should preface that if you are looking for a get-rich-quick scheme, then a DRIP is probably not the right strategy for you. Dividend reinvestment is geared towards long-term investors looking for a lower-risk investment approach and a steady income stream.
Many companies and funds share profits with their shareholders quarterly through dividend payments. Dividend reinvestment is the process of using dividend income to purchase more shares of the issuing company or fund automatically. For the most part, any investor can easily access dividend reinvestment programs through their brokerage firm or from dividend-paying stock with DRIPs. Even if a broker or company does not have an automatic dividend reinvestment program in place, you can manually reinvest the dividends.
Breaking Down How DRIPs Work
If we think about dividend reinvestment in two parts, first, you would buy shares in companies that pay dividends, such as Costco, Citigroup, AbbVie, and Kimberly Clark. Alternatively, you can invest in dividend funds, such as the Schwab US Dividend Equity ETF or SPDR S&P Dividend ETF. As long as the companies or funds pay dividends, you will receive a fixed payment for each share you own.
Second, you would use those dividends to purchase more shares of the underlying investment. So instead of receiving a cash payment, you would get more shares of the same stock or fund at the current market rate. While the dividend payment is usually less than the cost to purchase one share, you can receive fractional shares depending on the company or brokerage, which will compound over time.
In essence, a DRIP is a straightforward way to reinvest your money with minimal effort. While some companies charge investors fees for DRIPs, many companies nowadays offer no-fee DRIP stocks, which allow you to build larger positions in your favorite stocks for free.
Best Dividend Investment Plans to Implement
There are three main types of DRIPs:
Company Managed DRIPs: Hundreds of publicly traded companies run DRIPs for their shareholders at no additional cost and typically allow investors to initiate DRIPs even if they did not previously own shares. But, shares from company-operated DRIPs usually cannot get sold on the secondary market and must be repurchased directly from the company rather than through a broker.
Some companies have flexible options available for investors, such as full or partial reinvestment. For example, you can have a portion of your dividends get sent directly into your checking or savings account rather than reinvesting the full amount. Additionally, some firms offer discounted shares for investors who participate in their DRIPs, allowing you to get a better price than the current market price.
Note that if you want to have a company’s next dividend payout get applied to a DRIP, you need to enroll in the program by the stock’s record date.
Transfer Agent Operated DRIPs: Some companies will outsource the management of their DRIPs to third-party companies, such as EquiServe or Chase Mellon, due to increasing financial regulations or resource constraints. These companies, or transfer agents, specialize specifically in these types of services and often provide them at a lower cost than company-managed DRIPs.
Brokerage Firm Administered DRIPs: Many brokerage firms allow investors to reinvest their dividends at no cost, even if the dividend-paying companies do not have formal DRIPs in place. If you choose to enroll in a DRIP through your brokerage, you will have the option to:
- Automatically enroll all current and future dividend-paying investments,
- Enroll all current stocks and funds, or
- Enroll select individual investments.
If you choose the first option, as soon as you add new dividend-paying stocks or funds into your portfolio, they will get automatically added to the plan. And, when you receive a dividend payout, the money will get automatically reinvested. If you choose the second or third options, you will need to add new dividend stocks to your plan manually. So, before deciding which option to go with, consider how much control you want over your DRIPs.
A couple of years ago, I enrolled my Roth IRA in a DRIP through Fidelity for all my stocks and funds in the account. What I’ve liked about this plan so far is that there is no additional action required from me while my current investments will continue to grow year over year.
Making DRIPs Work For You
Because DRIPs emphasize investing for the long run, they keep investors focused on the future while avoiding attempts to time the market or making decisions based on short-term volatility.
Easy to Set Up
Enrolling in a DRIP is a painless and easy process. Most brokerages nowadays do not charge fees and allow investors to purchase fractional shares, thus enabling them to put their cash to work faster. Once you enroll in a DRIP, the dividends will get automatically reinvested into additional shares with minimal monitoring from you.
Cheaper Shares
A major advantage of DRIPs is the option to purchase additional shares at a discounted rate of 1-10% of the stock’s current market price. For example, the Healthcare Realty Trust Incorporated offers up to a 5% discount. That is the equivalent of 5% free money if you reinvest in the REIT (real estate investment trust)!
Low Transaction Fees
Some DRIPs offer lower fees than if you were to purchase the shares outright, while others charge no fees at all. While most online brokers waive trading fees nowadays, you may even be able to dodge fees from mutual funds by enabling automatic dividend reinvestment. Over time, the money saved from these fees, in addition to the ability to purchase fractional shares, will result in significantly more money in your hands.
Dollar-Cost Averaging
When you reinvest your dividends, you are dollar-cost averaging, meaning you will purchase the underlying asset regardless of whether the stock price is high or low. This process allows you to take advantage of the overall market trend and lower your risk since you are averaging your cost basis over time.
I’ve employed this strategy over the last few months by regularly investing in VOO, a popular S&P 500 fund, every month. With the markets trending downwards and a looming recession (as of October 2022), dollar-cost averaging has enabled me to put my investments on auto-pilot and remain calm during tumultuous times.
Flexibility
Because investors generally have several options for dividend reinvestment, they can usually invest as little or as much as they would like. You can pause your plans if you need cash for your daily expenses or discontinue them entirely if you no longer find the strategy valuable. You can make partial or full reinvestments, or pile up the cash in your account and manually reinvest the dividends. Alternatively, if you do not want to invest online, DRIP can be a valuable option for investing via mail.
Compound Interest
Compound interest is hands down one of the best reasons to enroll in DRIPs. Compound interest refers to the interest you earn on the principal and previous interest payments. Over time, compounding can exponentially grow your wealth with a minimal amount of effort, which is why it often gets described as “magic” or a “miracle.”
For example, if you put $10,000 into an S&P 500 index fund like VOO or IVV in 1970, you would have had more than $350,000 by the end of 2019 without factoring in dividends. If you reinvested your dividends back into the same fund, you would have more than $1.6 million within the same period. If your investment continues increasing in value over time and you keep reinvesting your dividends, you will benefit from compounding dividend growth.
Disadvantages of DRIPs
If you are a long-term investor, dividend reinvestment may seem like an attractive strategy for generating passive income. However, there are several drawbacks you should consider before using a DRIP.
May Require Minimums
Some companies require you to purchase a minimum number of shares to participate in a DRIP. If you are cash-strapped, that can limit what types of investments you can make through a dividend reinvestment plan.
Plans Can Vary
Each company and fund has different requirements and specifics for their DRIPs. Before you invest, do some research to figure out the logistics and details of the plan you are interested in. For example, some companies may require you to pay a one-time setup fee, while others may charge you $5 or $10 per transaction. While this amount does not sound like a lot of money right now, over time, this can add up and reduce your long-term returns.
Reinvesting in Underlying Asset
When you participate in a DRIP, you can only purchase the underlying stock or fund. In other words, if you want to buy a different investment, you will need to make the transaction on your own.
When looking at blue-chip stocks or growth stocks with dividends, their valuation matters a lot in this situation. Growth stocks can run up quickly and become overvalued, so if you are blindly reinvesting your dividends, you may end up overpaying for your shares, which increases the risk of your portfolio underperforming.
One way to address this issue is to conduct due diligence to determine which of your holdings are undervalued or fairly priced and reinvest the dividends into those assets instead. However, this will require some work on your end as you rebalance your portfolio.
Inflexible Reinvestment Schedule
If you participate in a DRIP, your dividends will most likely get automatically reinvested when the dividends get paid out. So, you will have less flexibility on when you reinvest your money. If you need cash for whatever reason, automating a DRIP will make it harder for you to fund other expenses using the cash from dividends.
Imbalanced Portfolio
If some of your stocks pay dividends while others do not, you may end up with disproportionately larger positions in your dividend stocks compared to the rest of your portfolio. If you are not regularly rebalancing your investments, that can reduce diversification and make your portfolio overreliant on dividend stocks.
Tax Treatment
Regardless of whether you opt to take your dividend payment as cash or reinvest it through a DRIP, you still have to pay taxes on them. This is not much of an issue if you only get a few hundred dollars in dividends annually. But, it can become problematic when you receive thousands in dividend payments and reinvest the entire amount. That is because you will need to come up with the money to foot the tax bill from other income sources.
Depending on the type of dividend paid and your taxable income, the rate can vary. The capital gains tax rate on qualified dividends ranges from 0%, 15%, or 20% depending on your taxable income and filing status, while the rate on non-qualified dividends ranges from 10%-37% depending on your income.
One way to avoid taxes is by investing in dividend stocks in a tax-advantaged account, such as a 401(k) or Roth IRA. But, keep in mind that these are retirement accounts, so you may need to pay hefty fines if you withdraw the money before age 59 1/2.
Best Dividend Reinvestment Plan Stocks to Consider
Like any investment, not all dividend stocks are created equal. When deciding which securities to invest in, look for high-quality dividend stocks. In particular, seek out blue-chip dividend stocks and Dividend Aristocrats, which tend to be shareholder-friendly companies that generate enough earnings or cash flows to pay dividends to their investors consistently. They are proven, high-quality companies with a strong history of rewarding investors in the long run.
Specifically, Dividend Aristocrats are S&P 500 companies with 25+ years of consecutive dividend increases and meet size minimums and liquidity requirements. They are businesses with strong competitive advantages and the ability to pay shareholders more dividends year after year. That means, each year, you will receive more shares and more dividend income, effectively creating a powerful compounding money machine.
These stocks tend to outperform the S&P 500 during recessions and exhibit lower risk, making them low-risk, high-reward investments. Examples of such companies include Microsoft, American Express, Becton, Dickinson & Company, AT&T, Kimberly-Clark, AbbVie, and Target.
Getting Started
If you want to reinvest your dividends, you will first need to decide if you would like to do so through your brokerage or directly through a company’s DRIP. Each brokerage account has its own process, but typically you can complete everything online in a few steps. If you want to start a DRIP with a specific company, contact their investors’ relations to get started.
The Bottom Line
A dividend reinvestment plan is a great way to start steadily growing your wealth and income over time. Many brokerages and companies allow DRIP investors to automatic this process, making it an easy and cost-effective way to compound returns and build wealth.
However, keep in mind that a DRIP is merely a tool for you to build wealth. Before you decide to reinvest your dividends, make sure to create a long-term investing plan tailored to your investment goals, risk profile, and time horizon. Whether you are interested in a DRIP for retirement income, passive income, or future growth, stick to your strategy through the good times and bad, and you will surely reach your financial goals.
