Dividend Reinvestment Plans: What You Need To Know
Some stocks pay dividends — quarterly or annual payments to shareholders based on how well the company performs over that period. For each share of the stock you own, you’ll get a small payment, based on how well the company performed the previous year.
When you own a dividend stock, you often have two options: take the dividends in cash or reinvest them in the stock, in what is known as a dividend reinvestment plan, or DRIP.
How a Dividend Reinvestment Plan Works
When you invest in a stock that pays dividends, you will either get a check from the company or have the dividends deposited into your brokerage account in cash. This is nice, but you don’t earn very much on invested cash these days.
An alternative to receiving dividends in cash is to enroll in a stock’s DRIP, which will automatically purchase additional shares of the stock with the dividends. You’ll need to be enrolled in the plan by the record date in order to have your dividends deposited into the DRIP.
The record date is the date by which you must own the stock in order to be entitled to the dividend. When a company announces a dividend, it typically announces the record date as well. It may say, “XYZ Corp. declared a 5-cent dividend payable on June 1 to shareholders of record on May 15.” In this case, you would have to have enrolled in the DRIP by May 15 in order for your dividend to be deposited into the plan.
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Some companies and mutual funds have their own DRIP programs. If the stock you’re invested in does not have one, check with your brokerage firm. Most of them will let you enroll in a DRIP so that you can reinvest your dividends.
Once you have enrolled in a DRIP, either with the company directly or at your brokerage firm, the process is automated. The company pays the dividend, it’s deposited into your account, and additional shares of the same position are purchased.
Benefits of Reinvesting Dividends
Dividend reinvestment is a little bit like compound interest — and the magic happens in a similar way. Because you are reinvesting your dividends, you’re buying additional shares of stock. Those additional shares of stock also generate dividends, which you then use to purchase even more shares. In other words, you get dividends, not only from the shares you bought in your original purchase but also from the shares you bought with your previous dividends.
Here’s an example. Suppose you purchased 100 shares of XYZ Company, which is a dividend-paying stock. The stock is trading at $100 per share and has just declared an annual dividend of $1.00 per share. The dividend is paid quarterly, so you get 25 cents per share ($1.00 divided by four quarters) in the first quarter, or $25. Since you’re enrolled in XYZ Company’s DRIP, your dividend is used to buy an additional quarter of a share of stock. By the end of the year, you have 101 shares of XYZ stock.
The next year, XYZ Company declares the same dividend. Now you own 101 shares, so you get a dividend of $25.25 each quarter. That money is also reinvested, and by the end of the year, you have 102.01 shares of XYZ Company. And so on.
Keep in Mind
Remember that while dividend stocks pay out dividends, they also (hopefully) increase in value, just like their non-dividend-paying counterparts. The increase may be more gradual than it would be if the company did not pay a dividend, but most stocks appreciate in value over the long term. So, by reinvesting the dividends into additional shares of a security that’s appreciating, you’re winning in two ways — you’ll have more shares of a stock or a mutual fund that’s worth more per share.
The Downside to DRIPs
DRIPs are usually a low-cost way to increase your portfolio, but some of them do have fees. Some direct DRIPs charge a commission on the securities that are purchased with the reinvested dividends. Be sure you understand what, if any, fees you may be subject to before you enroll in a DRIP.
If you enroll in a no-fee DRIP, offered by several brokerage houses, it can be a great way to add to your portfolio without paying commissions.
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It’s important to be aware of the tax implications of reinvesting dividends. In most cases, you will be taxed on dividends that are paid to you in the year they are paid, regardless of whether you reinvest them or not. If you receive significant dividends from your investments and you reinvest all of them, you may have an unpleasant surprise at tax time. Consult your tax advisor about how your dividends may be taxed.
What To Consider Before Investing
Just because a company pays a dividend and offers a DRIP doesn’t mean it’s necessarily the right stock for you. Be sure to do your due diligence, as you would with any investment, before you decide to purchase shares of a particular stock or mutual fund. And if you’re comparing two potential investments, be sure to factor in the dividends when making your decision.
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