What is a Dividend Reinvestment Plan and how does it work? Dividend Reinvestment Plan, short for ‘DRIP,’ is an innovative concept that enables investors to automatically reinvest their cash dividends back into the same stock they received the dividends from.
The dividends can either be invested into full shares, or fractional shares.
What Are the General Advantages of a DRIP Plan?
In plain terms, a DRIP plan may seem like a simple plan to buy extra shares. However, there are some subtle, and some more obvious advantages that it can bring along.
- In some instances, your trading platform may charge you commissions for buying and selling stocks; but, may not, for purchasing additional shares through DRIP.
- DRIP plans can also offer secondary level discounts for the same stocks. It’s just the organizations’ way of saying thank you. Saying, we know you could have used your cash dividend money for something else, so we appreciate you putting it back into our stock. In my opinion, this is huge!
- DRIP takes the concept of compounding further by continuously investing your money in the same stock. So with each passing dividend cycle, not only you increase your equity, you increase your gains.
What Are the Disadvantages of DRIP Investing?
In general, it’s beneficial all around, but for a more sophisticated and advanced investor, there could be a few disadvantages (although, depends on the perspective).
- Taxes: Dividends are considered taxable income. When you reinvest that money, technically, you’re not able to use your supplementary income to account for the extra tax. In other words, on paper, you earned cash, but you don’t really have that cash with you. This isn’t a bad thing necessarily, just laying it out there.
- Diversification: If you’re one of those investors, where you need to feel in control of every penny, DRIP isn’t for you. Plus, with every DRIP cycle, you’re losing opportunities for further diversification.
On a high level, three rules apply:
Rule 1: The company or organization that is publicly traded, needs to officially offer a DRIP plan to its investors.
Rule 2: Your trading platform needs to have the capability for a DRIP plan. This is especially important for users who want to leverage this as a strategy for their investment goals. If rule 2 doesn’t apply, then rule 1 becomes useless — in a manner of speaking.
Rule 3: In some cases, companies may have a minimum dollar requirement for you to buy additional shares or fractional shares via DRIP. For example, Company X could say that in order for you to buy their shares through DRIP, you need to be earning at least $10 in dividends.
That’s completely fine. Even if your trading platform has room for DRIP, you aren’t required to participate in it. Plus, you should be able to turn it off anytime. An excellent stock investment platform, however, should be able to grant more flexibility where you can pick and choose for which companies you want a DRIP, and which you don’t. Robinhood has that feature.
The answers to both these questions depend on who you’re trading stocks with. Some may have commissions in general, but may charge an extra commission just to let you invest in a DRIP plan.
How Do DRIP Plans Work?
I believe by this point, you already have an idea of what DRIP is. From the technical side of things, as far as the money goes, with DRIP, you’ll likely never see your dividend cash in your brokerage account or in your bank account (depending on your configurations). Instead, everything will work programmatically in the background where the dollar value from the dividends is directly re-allocated.
The essence of a DRIP plan lies in its automation of the following key objectives:
- Hassle-free reinvestment.
- Worry-free allocation of your cash dividends themselves — including fractional shares.
- Discounted re-purchases (if offered) of the same stock.
- Growing your net equity in an organization you believe in — and thereby, your dividends as well.
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At the time of writing this post, I believe there are numerous trading platforms offering DRIP plans to its users.
As a hobbyist investor, (like I am), a DRIP plan can work in your favor. However, if you’re a more discerning investor who likes to account for every penny, a DRIP plan might not necessarily be for you; although, I think you can achieve a balance of both by having DRIP on specific companies only — as opposed to your entire portfolio.