Advantages of Dividend Reinvestment Plans

A dividend reinvestment plan (sometimes referred to as DRIP) is the reinvestment of dividends by shareholders as a means to purchase additional shares (or fractions of shares if there isn't enough to buy complete shares).  When it comes time to issue dividend checks to shareholders, those that have decided to take advantage of the dividend reinvestment plan are not going to receive a dividend check- instead that money will be used to purchase more shares in the company.

Dividend reinvestment plans can be run by the company that you own stock in, or by the brokerage firm.  If the DRIP is operated by the company itself, the shares purchased with the dividends are taken out of the company's reserve and not purchased from the secondary market.  If a shareholder wants to sell the shares purchased through the dividend reinvestment plan, they do not go back on the market- instead, those shares are sold back to the company that issued the shares at the current market value.  When the DRIP is operated by a brokerage firm, the firm will purchase additional shares using your dividends from the secondary market.  When you sell those shares, they are also returned to the secondary market.

Benefits of Reinvesting Dividends

There are numerous benefits to reinvesting your dividends for investors.  First, when a company operates their own dividend reinvestment, the shares purchased with those dividends are not charged commission as there is no need for a broker to handle the trade.  Small investors benefit greatly from this arrangement, since they typically have to save for long periods of time in order to have a large enough sum to invest to make it worth paying the commission fee.

In some dividend reinvestment programs, shareholders have the ability to purchase more shares with cash during the reinvestment period.  The shares can be purchased without commission fees, and usually offered at a discounted price of up to 10%.

Additionally, dividend reinvestment programs often use dollar cost averaging.  This means the investor is not purchasing the stocks at the highest or the lowest- instead, the amount is averaged over a long period of time and you typically get a better deal.

Company Benefits of DRIPS

Why would a company want to bother with a dividend reinvestment program just to sell a few shares with shareholder dividends?  DRIPS provide access to capital because the shares are purchased directly from the company which allows the company to reinvest those funds into the company itself.  When stocks are purchaed through the exchange, you buy from another investor and the company doesn't actually benefit from the sale.

Dividend reinvestment programs also encourage long term investors to become shareholders.  It helps companies maintain a stable shareholder volume as they aren't as likely to sell their shares with every downturn of the market.

Taxation of DRIPS

It's a common misconception that investors have regarding dividend reinvestment programs that the invstor does not have to pay tax on the dividends.  Unfortunately, that's not the case- even though you aren't receiving the dividend check in your hands, that cost-effective investment is subject to tax as it is considered income.  The capital gains of stock is not calculated and subject to tax until you sell your stock shares, and the dividend reinvestment program capital gains work in the same manner.