A dividend reinvestment plan (DRIP) lets you buy shares of stock in a company with the dividend payments from that same company. Investors who opt into a DRIP take advantage of dollar-cost averaging, compounding returns, and potential discounts on stock purchases to help maximize the value of their dividend investing strategy.
What Is DRIP Investing?
Dividend investing is a popular strategy for generating income and saving for retirement. When you buy dividend stocks, the companies you own pay you a portion of their earnings as dividends, based on the number of shares you own. Dividends provide cash flow from your stock investments without requiring you to sell shares.
Investors can save their dividends, invest them or spend them as regular income. A dividend reinvestment plan automatically purchases more shares of a company’s stock with the dividends they pay out, whether that’s each month, quarter, or year.
Not all public companies that pay dividends offer a DRIP. If a company you invest with doesn’t offer a DRIP, your brokerage may enable you to reinvest dividends automatically.
Advantages of DRIP Investing
DRIPs help you take advantage of dollar-cost averaging. With a dividend reinvestment plan, you buy shares of stock at regular intervals, which may lower the average price you pay per share over time. In addition, you may be eligible to pay less per share through DRIP plans that discount the current market share price for investors who reinvest their dividends.
Dividend reinvestment plans are also an excellent way to generate more compound returns. Investment returns compound over time, and reinvested dividends provide you with even more compound growth. According to an analysis from Hartford Funds, 78% of S&P 500 returns going back to 1978 can be attributed to dividend reinvestment and their resulting compound returns.
Here’s how that plays out: Let’s say you invested $10,000 in PepsiCo (PEP) in October 2010 and reinvested all dividend payments for a decade. Your initial investment would have bought 153.82 shares of PepsiCo. After a decade of dividend reinvestment, you would own 206.54 shares worth more than $28,800. That’s an increase in over 50 shares and almost $19,000 without spending more of your money to buy new shares.
In the past, DRIPs offered some other advantages that have become less relevant. DRIPs often charged zero commissions when commissions ran high for stock purchases. They also gave investors access to fractional shares, which get dollar amounts too small to buy whole shares into the market. Today, many brokerages charge zero commissions on stock trading and offer fractional shares of many leading stocks, diminishing these DRIP advantages.
How to Start DRIP Investing
There are several places to find DRIP stocks for your portfolio. You might start with the dividend aristocrats, a list of companies with a long history of raising their dividends yearly. To be considered a dividend aristocrat, a company must have increased its payout annually for 25 consecutive years.
Not all stocks can be aristocrats, but plenty of companies pay regular, reliable dividends. As you research companies, look at their dividend histories to determine whether they’ve been paying consistently over time—even if they haven’t increased the payout.
Once you’ve determined which companies you want to invest in, you have a few options for DRIPs:
- Company-Operated DRIPs. A few large-cap companies that pay dividends operate their DRIPs. Dow Jones Industrial Average (DJIA) members Coca-Cola (KO) and Johnson & Johnson (JNJ) manage their direct stock purchase plans, which let you buy stock directly from them instead of a brokerage, as well as DRIPs, which reinvest the dividends earned on the stocks you buy through them.
- Third-party DRIPs. Most dividend-paying companies outsource the management of their direct stock purchase plans and DRIPs to third parties, referred to as transfer agents. Computershare is one of the leading transfer agents, and its search portal is a great place to research and sign up for DRIPs. Keep in mind with company-operated and third-party DRIPs that, you may have to pay fees to start investing or to buy subsequent shares; you can generally find brokerages that lack these fees. Brokerages will also allow you to invest in (and use DRIPs for) more than one company’s stock and even mutual funds and exchange-traded funds (ETFs), which are helpful for diversification.
- Brokerage DRIPs. Many brokerages facilitate DRIP investing. Simply choose your dividend stocks or funds, opt into your brokerage’s DRIP, and when you receive a payout in your brokerage account, your brokerage will automatically reinvest in new shares.
- DIY DRIPs. Suppose you want to invest in a dividend company that doesn’t offer a DRIP, and no third parties or brokerage can facilitate dividend reinvestment for you. In that case, you can manage dividend reinvestment yourself. Simply purchase shares and fractional shares that reflect the dollar value of your dividend payment. If no fractional shares are available, hold onto the money until you have enough to buy whole shares. This DRIP process is more labor intensive, but you can still benefit from compound returns and dollar-cost averaging.
DRIP Investing and Taxes
A dividend is considered taxable income, and even if you directly reinvest your dividends without seeing them in your account first, they’re still reported to the IRS as income.
Dividend income is listed on Form 1099-DIV as either non-qualified or qualified. You should receive this form from your brokerage or direct stock purchase provider. Non-qualified dividends are taxed at your ordinary income rate. In contrast, qualified dividends, which most dividends from U.S.-based stocks and funds are, get favorable tax treatment similar to long-term capital gains taxes.
It’s important to note that dividends from real estate investment trusts (REITs), employee stock options, or master limited partnerships (MLPs) are not qualified dividends.
Should You Set Up DRIP Investing?
DRIP investing can make a ton of sense for beginners hoping to grow their portfolios faster through compounding returns. It provides free shares that entitle you to more dividends that you can use to buy even more shares. Then you’re even better posed to benefit from any increases in stock price. Remember: Many of the S&P 500’s long-term returns have been from reinvested dividends.
However, if you’re already past the growth phase of your portfolio and you’re planning to live off your dividend income, it might make sense to stop with the DRIPs and start using the income they generate for everyday expenses.
