Why is the Dividend Reinvestment plan so important?
A dividend reinvestment plan, or DRIP, allows investors to reinvest the cash dividends they receive from their stocks into more shares, or fractional shares, of that stock.
Hundreds of companies, funds, and brokerages offer DRIPs to shareholders. Although some stock exchanges offer automatic dividend reinvestment, this is different from a formal DRIP. Reinvesting dividends through a DRIP may come with a discount on share prices or no commissions.
Of course, it’s possible to simply keep the cash dividends to spend or save, or use them to buy shares of a different stock. In order to decide what’s best for your financial plan, it helps to know the pros and cons of a dividend reinvestment plan and how it works.
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What’s a Dividend?
First, some basics about dividends themselves. A dividend is a payment made from a company to its shareholders (people who own shares of their company’s stock).
Dividends are often drawn from a company’s earnings and paid to shareholders on an annual or quarterly basis. While they’re typically paid in cash via direct deposit or a check, in some cases a company might elect to pay dividends via additional shares. Either way, dividends are subject to tax.
Not all stocks pay dividends, though. Growth stocks, for example, are less likely to offer a dividend, as these companies typically reinvest all of their profits in further growth.
If you buy a dividend-paying stock and want to qualify for a dividend payout, you must own the stock before its ex-dividend date. This is a date set by the company that determines which shareholders are eligible to receive an upcoming dividend payment.
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Dividends Paid on Per-Share Basis
Dividends are paid on a per-share basis. Dividend per share (DPS) represents the total amount of dividends per individual outstanding share of stock in a company.
There are two ways to calculate dividend per share:
Total dividends paid/Shares outstanding = Dividend per share
Earnings per share (EPS) x Dividend payout ratio = Dividend per share
In this second formula, earnings per share is a company’s net profit divided by the number of outstanding shares. This is a key metric that’s used to assess a company’s profitability.
The dividend payout ratio (DPR) reflects the total amount of dividends that are paid out to shareholders, relative to a company’s net income. This metric can tell you at a glance what percentage of its profits a company pays to investors as dividends versus reinvesting in growth.
What Is Dividend Reinvestment?
Dividend reinvestment typically means using the dividends you receive to purchase additional shares of stock in the same company (although technically you can reinvest in any company’s stock). So if you’re asking, Should I reinvest dividends? what you may want to know is whether you should use your dividends to buy more of the same stock.
Here’s how it works. If you own 20 shares of a stock that has a current trading value of $100 per share, and the company announces that it will pay $10 in dividends per share of stock, then the company would pay you $200 in dividends that year.
If you choose to reinvest the dividends, you would own 22 shares of that stock ($200 in dividends/$100 of current trading value = two new shares of stock added to your original 20). If the stock price was $200, you’d be able to purchase a single share; if it was $50, you could theoretically reinvest and own an additional four shares.
If instead, you want cash, then you’d receive $200 to spend or save, and you’d still have the initial 20 shares of the stock.
When you initially buy a share of a dividend-paying stock, you typically have the option of choosing whether you’ll want to reinvest your dividends automatically. Let’s look at how those plans work.
Dividend Reinvestment Plans
Depending on which stocks you invest in, you may have the option to enroll in a Dividend Reinvestment Plan or DRIP. This type of plan, offered by about 650 companies and 500 closed-end funds, allows you to automatically reinvest dividends as they’re paid out into additional shares of stock.
So should you reinvest dividends with a DRIP?
Pros of Dividend Reinvestment Plans
You may have heard that Albert Einstein once said that the most powerful force in the universe was compound interest. The story may be apocryphal, but it’s true that one of the best reasons to reinvest your dividends is that it helps to position you for potentially greater long-term returns, thanks to the power of compounding.
Generally, if a company pays out the same level of dividends each year — whether that’s 2%, 3%, or another amount — and you take your dividends in cash, then you’ll keep getting the same amount in dividends each year (assuming you don’t buy any additional shares).
But if you take your dividends and reinvest them through a DRIP, then you’ll have more shares of stock next year, and then more the year after that — which means that the dollar amount of the dividends (at least in our example where the payout percentage is the same each year) will keep rising. Over a period of time, the amount you would receive during subsequent payouts could increase significantly.
An important caveat: Real-life situations aren’t often as straightforward as this example, of course. For one thing, stock prices aren’t likely to stay exactly the same for an extended period of time.
Plus, there’s no guarantee that dividends will be paid out each period; and, even if they are, there is no way to know for sure how much they’ll be. The performance of the company and the general economy can have a significant impact on company profitability and, therefore, typically affect dividends given to shareholders.
From a long-term historical perspective, though, stocks have provided financial growth and, when dividends are reinvested, the effect of compounding can provide significant benefits.
There are more benefits associated with DRIPs:
• You may get a discount: Discounts on DRIP shares can be anywhere from 1% to 10%. Investors can also purchase fractional shares through DRIPS. This is useful because dividend payments may not be enough to buy an entire share of the stock.
• Zero Commission: Most DRIP programs can allow you to buy new shares without paying commission fees. However, many brokerages offer zero-commission trading outside of DRIPs these days.
• Fractional Shares: DRIPs may allow you to reinvest into fractional shares, rather than whole shares that may be at a pricier level than you wish to purchase.
• Dollar-cost averaging: This is a common strategy investors use to manage price volatility. You invest the same amount of money on a regular cadence (every week, month, quarter) no matter what the price of the asset is. This is generally smarter than trying to time the market.
Cons of Dividend Reinvestment Plans
Dividend reinvestment plans also come with some potential negatives.
• The cash is tied up. First, reinvesting dividends obviously puts that money out of reach. That can be a downside if you want or need the money for, say, home improvements, a tuition bill, or an upcoming vacation.
• Risk exposure. You should also keep potential risk factors in mind. For example, you may have concerns about the stock market in general, or about the particular company where you’re a shareholder, and reinvesting your cash into more equities may seem unwise. Or you may need to rebalance your portfolio. If you’ve been reinvesting your dividends, and the stock portion of your portfolio has grown, using a DRIP could inadvertently put your allocation further out of whack.
• No flexibility. Another factor to consider is that when your dividends are automatically reinvested through a DRIP, they will go right back into the company that issued the dividend, giving you no choice as to where to put those funds. Perhaps you’d simply rather buy stock from another company.
• Less liquidity. Also, when you use a DRIP and later wish to sell those shares, you must sell them back to the company. DRIP shares cannot be sold on exchanges.
Cash vs. Reinvested Dividends
Should I reinvest dividends or take cash instead? How you approach this question can depend on several things, including:
• Short term financial goals
• Long term financial goals
• Income needs
Accepting the cash value of your dividends can provide you with ongoing income. That may be important to you if you’re looking for a way to supplement your paychecks during your working years, or other income sources if you’re already retired.
As mentioned earlier, you could use that cash income to further a number of goals. For instance, you might use cash dividend payouts to pay off debt, fund home improvements, or put your kids through college. Or you may use it to help pay for long-term care during your later years.
You might consider a cash option for dividends rather than reinvesting dividends if you’re already building sufficient wealth for retirement in your portfolio. That way you can free up the cash now to enjoy it or address other current priorities.
Cash may also be more attractive if you’re comfortable with your current portfolio configuration and don’t want to purchase additional shares of the dividend stocks you already own.
On the other hand, reinvesting dividends automatically through a DRIP could help you to increase your savings for retirement. This assumes, of course, that your investments perform well and that the stocks you own don’t decrease or eliminate their dividend payout over time. Choosing Dividend Aristocrats or Dividend Kings could help to hedge against the possibility of dividend cuts.
Dividend Aristocrats represent a select group of companies that have increased their dividend payout year over year for at least 25 consecutive years. The Dividend Kings are an even more elite group of companies that have increased dividend payouts year over year for 50 consecutive years or more.
Tax Consequences of Dividends
One thing to keep in mind is that dividends — whether you cash them out or reinvest them — are not free money. There may be tax consequences when you receive dividends because if the amount is significant enough, you might need to pay income taxes on what you’ve earned.
Each year, you’ll receive a tax form called a 1099-DIV for each investment that paid you dividends, and these forms will help you to determine how much you owe in taxes on those earnings.
Dividends are considered taxable whether you take them in cash or reinvest them — even though when you reinvest, the money isn’t currently available for you to spend.
The exception to that rule is for funds invested in retirement accounts, such as an online IRA, as the money invested in these accounts is tax-deferred. If you have received or believe you may receive dividends this year, it can make sense to get professional tax advice to see how you can minimize your tax liability.
Should You Reinvest Dividends?
Reinvesting dividends through a dividend reinvestment plan is partly a short-term decision, and mostly a long-term one.
If you need the cash from the dividend payouts in the near term or have doubts about the market or the company you’d be reinvesting in (or you’d rather purchase another stock), you may not want to use a DRIP.
If on the other hand you don’t have an immediate need for the cash, and you can see the value of compounding the growth of your shares in the company over the long haul, reinvesting dividends makes sense. And using a DRIP, which may offer some cost savings, could be a smart way to go.