Dividend reinvestment plans (better known as DRIPs) sound complex in nature, but are fairly simple in definition. When a dividend is paid by a company, you have 2 options:
#1 You receive your dividend payout in cash in your investment account
#2 The dividend payout is automatically reinvested in the same investment issuing the dividend
Essentially what happens is that instead of receiving your dividend payment via cash, you instead have the option to use this payment towards purchasing more stock in the company.
By agreeing to a dividend reinvestment plan the investor is increasing their stock holdings. The investor’s cash account will not increase but they will own more and more shares every quarter. This is an ideal option for the investor with a long term mind set. The amount of shares purchase as part of a DRIP plan depends on how much money you’re owed as a dividend payment as a result of your stock holdings.
What is the benefit of a dividend reinvestment plan?
The benefit is that the investor has the option to purchase more shares in the company without going through their brokerage. The investor automatically reinvests their money because they purchase more stock in the company. Therefore, you put your investing on auto-pilot and you grant the company permission to use your cash payment to buy more shares at the given price. You also get to avoid brokerage fees in most cases.
The other benefit is that you don’t have your dividend payments sitting around in a cash account. You also don’t have this money available to spend foolishly. Instead the money is used to reinvest in the company that you originally started investing in.
Finally, some companies offer a bonus to investors who subscribe to their DRIPs. They can offer the investor to reinvest their dividend through buying shares with a 5% rebate on the stock market value for example. So if the stock is trading at $100, you will be able to reinvest your dividend by buying shares at $95.
A word of warning on DRIPs
New investors must watch out for a common mistake that occurs here. When you use your dividend payment to purchase more stocks in the company this is NOT FREE MONEY. You’ll be taxed on this. So we ask you to please consult your tax adviser if you have any further questions on DRIPs and taxation, especially if you are preparing and filing your own tax returns. If so, we also highly recommend an up-to-date online tax software program such as TurboTax to ensure that your returns are accurate.
There is also a possibility that your brokerage account doesn’t offer DRIPs. This is important to consider this factor before choosing your brokerage firm and open a trading account.