The Basics of Dividend Reinvestment Plans: How To Compound Your Wealth

A dividend reinvestment plan, or DRIP, is an investment program designed to slowly compound your shares in a chosen company. It works by automatically reinvesting your incoming cash dividends towards the purchase of additional shares. This allows you to slowly compound your dividend returns, drop by drop.

In many cases, making use of a DRIP will not only automate the process of reinvesting cash dividends, but it can also get you access to discounted share prices. It can be a great option for many investors, especially for those looking to increase their passive investments. That said, it helps to have a full picture of the benefits and potential drawbacks before fully committing to a DRIP. 

What is DRIP Investing?

DRIPs are investment programs offered by many companies giving investors the chance to automatically reinvest your cash dividends into purchasing more shares. In this way you can increase your share percentage and strengthen your position, while often purchasing additional stock at a discount. 

You can also set up a synthetic DRIP through a brokerage if it isn’t offered already by a company you’ve invested in.

Some DRIP programs will offer investors a flat-rate percentage discount on reinvested dividends, while others will waive the typical transaction fees. Along with the automation benefit (set it and forget it) these discounts are a major pull for investors to enroll in a DRIP.

Of course, DRIPs are elective, so you won’t ever be forced into one. And depending on your broker, you may have access to DRIPs through stocks, ETFs, mutual funds, and more.

How Does DRIP Investing Work?

DRIP investing is relatively straightforward, at least in theory. Enrolling in a DRIP program means that whenever dividends are issued, you’ll see that cash go straight toward the purchase of more shares from that specific investment. So instead of receiving a paper check or direct deposit, your dividends will go directly towards purchasing additional stock.

In addition, some companies offer flexible reinvestment options for DRIPs, in particular when it comes to partial reinvestment. This means you can choose to reinvest the full dividend amount, or a partial amount (expressed as a dollar percentage or number of shares). If you’ve got a significant investment and prefer to still have some cash flow into your bank account, a partial DRIP can be ideal. 

There is also flexibility around how you use a DRIP throughout your portfolio: you can choose to open a DRIP for an entire account, or just focus on individual securities. 

Furthermore, some companies and brokerages will allow DRIPs to purchase fractional shares, meaning your dividend doesn’t have to cover the cost of a whole share in order to be directly reinvested. That said, there are almost always dollar minimums that must be met in order to fulfill a DRIP. 

According to TD Bank, DRIP programs are a great opportunity to regularly participate in a company's growth, while also taking advantage of the dollar-cost averaging (DCA) strategy. And while those two points are sure to be considered among the benefits of a DRIP, it’s worthwhile to weigh all of the pros and cons together before diving in.

Pros of DRIP Investing:

• Dollar-Cost Averaging (DCA): When you choose to automate your purchase of any security as a recurring investment, you are practicing dollar-cost averaging. Rather than trying to time the market and buy at a certain price, DCA works to average out your overall share cost over time by purchasing at automated or random intervals, reducing risk.
• Compound Returns: Taking advantage of a DRIP is a great way to generate compound returns, and passively increase the strength of your position in an investment. Your investment returns will compound over time and eventually snowball into a large investment, which is perfect for the growth phase of any portfolio.
• Set it and Forget it: When you commit to automatically reinvesting your dividends into additional shares, you won’t ever have to worry about the possibility of forgetting to reinvest. This completely removes the chance of accidentally spending your dividends, or allowing them to slowly drain away.
• Lower Fees: In many cases, DRIPs set up through a brokerage firm will benefit from a reduction or elimination on the cost of commissions for reinvested dividends. This is an easy win that will send more of your cash straight back into your investment. Not all brokerage firms will provide commission-free DRIPs, however, so be sure to check that out beforehand if using a broker.
• Stock Discounts: Some companies will offer discounts on shares purchased via DRIPs. in some cases these discounts can be as high as 5% off the regular share price, making it an attractive deal on a position you already plan to solidify long-term.

Cons of DRIP Investing

• Minimum Shares: Many companies will require investors to own a certain number of shares before offering a DRIP. While that number might be low, it can still restrict access to DRIPs for some investors.
• Taxation: Generally speaking, your dividends will be considered taxable income, and that won’t change if you’ve got a DRIP set up. Even if you reinvest your entire dividend, you’ll still be obligated to pay the applicable tax on that income. DRIP investors must take that into consideration when filing taxes for income. But the dividend amount can be added to the adjusted cost base so there will be less tax to pay when the security is finally sold.
• Risk of Concentration: If you’ve got a DRIP set up for certain securities and not others, you’ll have to factor that into your portfolio diversification. Over time you’ll run the risk of creating an imbalance by concentrating certain positions, and potentially taking on unnecessary risk. 

Setting Up a Dividend Reinvestment Plan

All things considered, DRIP investing is still a useful strategy for compounding investments and growing portfolios. If you’re interested in pursuing one, there’s a few different routes you can take towards setting up a DRIP. Primarily, you’ll need to decide which type of reinvestment plan you want to pursue.

You can seek out company-operated DRIPs, where both stock purchases and DRIP programs are offered. Typically, only large-cap corporations will offer a direct DRIP program. Using a company-operated DRIP means you’ll only be able to reinvest in that company’s stock.

While some large companies operate their own DRIPs, many outsource these investment programs to third parties known as transfer agents. It’s still relatively easy to set up a DRIP with an online account in such cases, however you’re likely to run into some processing fees.

If you decide to go through your brokerage, you may have access to DRIPs for both stocks and funds that pay dividends, as well as the chance to invest in fractional shares. Plus, you can ask about reinvesting dividends in a more diversified manner across your portfolio. 

Many online brokers allow you to quickly set up a DRIP account online, but the process can vary between brokers. You can check with customer support or speak directly to your broker to get started.

Setting up a DRIP account directly with a company will require contacting investor relations at the company. And if the company pays dividends but doesn’t currently offer a DRIP, you can take that to your broker and set up a reinvestment plan with them instead. 

Steven Brennan is a finance content writer based in Vancouver, British Columbia. He commonly writes about loans, credit cards, investments and digital currencies. In addition to writing personal finance content, Steven also writes for a PR agency, helping finance clients land links in media publications such as Forbes, Business Insider, and others.

Steven holds a BA in Philosophy and English, and an MA in World Literature, both from The National University of Ireland Maynooth.