MLR

DRIPs: Know the pros and cons

Dividend reinvestment plans offer advantages to investors, but the disadvantages should be considered.

share of stock

Commonly called DRIPs, these plans allow shareholders to buy stock directly from a company or from the company’s transfer agent. The plans also reinvest part or all dividends paid, as chosen by the shareholder, into more stock for the investor.

Most, but not all, DRIPs allow dividends to be reinvested without a fee. They may be run by the company itself or by a transfer agent, such as a large bank or financial institution.

Usually, it is a condition of enrollment in a DRIP that you already own at least one share of stock. However, some companies offer direct stock plans that allow you to purchase your first share at the time you enroll.

One advantage of a dividend reinvestment plan is you don't need large amounts of money to start.

Some plans may allow investors the option of enrolling in an individual retirement account DRIP. Some brokerages also offer DRIP plans – even if companies don’t offer them – that allow reinvestment of dividends without fees.

One advantage of a DRIP is you don’t need large amounts of money to start. Often, one share of stock will be enough.

Most DRIPs run by companies or their transfer agents also allow optional additional purchases of stock, up to a certain limit, for nominal or no fees – a feature called an “optional cash purchase.” The minimum required investment for optional purchases can be less than $25 in many companies, making DRIPs an easy way for investors to purchase in small increments.

Another potential advantage is discounted purchasing. Some companies may allow dividend reinvestment at discounts ranging from 1 percent to 10 percent of the market price, thus in a sense providing an immediate return on investment. Discounts in some DRIPs may apply to optional cash purchases as well.

DRIPs are a convenient way to invest, possibly at a discount, in a particular company regularly in small increments over a long period of time.

However, the convenience of a DRIP does not dispense with the need to consider whether the underlying investment is a good one or whether an investor is adequately diversified. Each DRIP is different, so read the prospectus carefully, noting any fees for purchase or sale or for servicing or maintaining the account.

Other variables can include whether the investor is permitted to take part of the dividend in cash and reinvest the remainder, how to terminate the DRIP, and at what times and under what terms optional cash purchases are permitted. If there is a discount on purchase, does it apply only to reinvested dividends or also to optional cash purchases?

DRIPs offer advantages but also have drawbacks. One disadvantage to DRIPs is the inability to sell or buy as quickly as you could if you owned the shares in a regular brokerage account. In a regular account, you can respond more quickly to a rise or fall in the market, thereby having some control over the price at which the stock is bought or sold.

However, with a DRIP, requests for optional cash purchases or termination of the DRIP are processed according to the rules of the DRIP. For example, under the DRIP rules, your request for an optional cash purchase might not occur until weeks later. By that time, the low price that motivated you to make the optional purchase may have risen considerably.

DRIPs and direct stock purchase plans are not suitable for investors wishing to hold only short term.

Bookkeeping overload can be another disadvantage. Each dividend reinvestment or optional cash purchase has its own basis for capital gains purposes based upon the purchase price and adjustments for fees, if any. The discount in an optional cash purchase is treated as an additional dividend by the IRS and factors into computation of the basis.

You will need to keep track of the dividend payment dates, save all financial statements and otherwise keep detailed records to be able to figure out capital gains when disposing of the stock.

Another potential disadvantage to dividend reinvestment is that you have taxable income – a dividend – but without receiving cash that can be used to pay the tax.