What Is A DRIP Stock?
Drip stands for ‘dividend reinvestment plan.’ It is a program that an investor can automatically use stock or fund dividends to purchase more shares using the dividend-paying tool. Investors can reinvest their current dividends into a stock or fund instead of paying cash to buy additional shares.
Critical: Investors need to know that dividends invested using the DRIP plan will be taxable based on an investor’s income. They will be taxed the same way as dividends that you may receive in cash or check form. Qualified dividends are taxed based on an investor’s tax bracket: 0%, 10,% or 20%.
What Is A Dividend Reinvestment?
Dividend reinvestment is when an investor chooses to have investment shares to buy more dividends of an investment. The investor decides to allocate the money from the investment back into their investment rather than receive it from the investment in cash or check. The typical investor who will reinvest their dividends has a long-term view of their investment, which may be in a stock, mutual fund, or exchange-traded fund (ETF).
Dividend Reinvestment Plan Example
For an example of how the Dividend Reinvestment Plan works, let’s work through an example of an investor who owns 100 shares in a company’s stock. The investor decided to DRIP the dividends into the company’s stock. The company pays a $0.30 per share quarterly dividend, and the stock price is $30 per share.
DRIP calculation stock example:
100 shares x $0.30 dividend = $30 reinvestment to buy 1 total share at $30 per share.
The investor has decided to receive one additional share rather than collect the $30 in cash.
Critical: A DRIP reinvestment plan can result in the purchase of fractional shares for an investor. The shareholder in the above example who owns 100 shares in company stock with a $0.30 dividend payout would receive a partial share if the stock price rose to $33. The DRIP would then buy $0.90 a share. It would be less than a total stock or the purchase of a fractional share in a company.
Advantages Of DRIP For Investors
Simple: A DRIP reinvestment program can be easily set up with the issuing company or dividend reinvestment through a brokerage. This makes dividend reinvesting simple to maintain.
Compounding Effect: Reinvesting dividends can create a compounding effect on the investment. As the investor’s share number increases, each consecutive stock or fund purchase will increase future dividend payments for the investor. This is because the investor is using the DRIP method to reinvest to buy more of a company’s shares.
Dollar-Cost Averaging: The DRIP reinvestment plan automatically makes purchases for the investor over regular intervals. It will reinvest according to the company’s payout time which could be monthly or quarterly. The investor can dollar-cost average (DCA), which increases an investor’s holding in a stock or fund over time as the price fluctuates using the DRIP method. The result will be an increase in future dividend payments for the investor. The investor may buy fractional or whole shares of a stock or fund, depending upon the amount of DRIP and the price of the stock at the time of reinvestment.
Disadvantages Of Using DRIP For Investors
No Control Over Timing Of Purchases: As an investor, you will have no control over the timing of your purchases in a company’s share. Many companies that pay a dividend have a payout quarterly for dividend payment, and the DRIP reinvestment plan will happen on this same schedule. If the stock rises, you will be able to purchase fewer shares in a company compared to if you bought them on your own at a lower price, not using the DRIP method.
Tracking Cost Basis: A DRIP reinvestment strategy can complicate your process for keeping investment tax records. Each dividend reinvestment will have its cost basis, making capital gains taxes more convoluted. Still, most brokerage companies send you a document with your tax information at the end of each year.
Income Tax Implications: Dividends from a DRIP stock or another investment that pays dividends as income within an investor’s calendar year. This is true even if an investor reinvests into a stock or fund using the DRIP reinvestment plan. An investor could create an Individual Retirement Account (IRA), where an investor reinvests the dividends in a tax-advantaged account.
The DRIP reinvestment plan has multiple benefits for investors: simple, compounding effect, and dollar-cost averaging. The most significant disadvantage is how DRIP can complicate an investor’s taxes. You are responsible for your financial decisions as an investor since you know your situation and what works best for you.