If you have retirement savings accounts, college savings accounts or a brokerage account (maybe you’ve got them all) you already know that investing is a key component of building wealth over the long term. But are you using every tool available to further enhance your potential for growth?
One of those tools is known as a dividend reinvestment plan, or DRIP, and it’s a simple, automatic way to reap the benefits of compound interest and dollar-cost averaging. Here’s how to maximize your savings with DRIP.
WHAT IS DRIP?
To reap profits from stocks, you can sell your shares for a higher price than you paid or you can collect dividends from shares you own (or both, of course). Companies pay dividends monthly, quarterly, annually or even randomly (known as special dividends), to their shareholders. Once they’re issued you’ll get a small cut of cash for every share you own, and that total payout is added to your investment account cash balance or, in some cases, sent to you as a check.
If you’re retired and rely on investments for income, taking dividends as cash may be precisely what you want. But if you’re still in the market for long-term growth, you may want those dividends to go to work for you rather than sitting as cash.
A DRIP immediately plows dividends back into the underlying investment to buy more shares of that stock. So, when the next dividend is issued all those additional shares you just purchased will also earn dividends. If those dividends are reinvested again, you’ll buy even more shares that may earn even more dividends next time.
WHY INVESTORS LIKE DRIP
There are several advantages to setting up DRIP on one or more of your individual stocks.
No trading fees. When buying a stock through your broker, you’ll likely pay a commission or other fees (although that's changing quickly). However, many brokerages waive those fees when your investments are purchased automatically through DRIP. In some cases, purchases made through DRIP actually give you access to discounted share prices — typically 1 to 10 percent below the market price. However, nabbing that discount may mean you agree to hold the shares for a minimum amount of time before selling.
Automate dollar-cost averaging. Dollar-cost averaging involves investing small amounts of money regularly, say every month, rather than investing a large sum all at once. By spreading investments over a longer time frame, you’ll buy shares when the price is high but also catch periods when the price is low. Over time, it can reduce the impact of volatility and may help you average into a better price. DRIP, by its design, helps you incorporate dollar-cost averaging automatically.
Purchase fractional shares. Typically, you’re required to buy whole shares when you invest. But DRIP lets you own fractions of shares. So instead of waiting until you have enough cash to buy an entire share of stock, DRIP buys you whatever full and fractional shares your dividends can purchase at the current price.
A FEW THINGS TO CONSIDER ABOUT DRIP INVESTING
Selling fractional shares. As shares trade as a whole, when you sell an entire position (all your shares) the remaining fractional shares will be deposited into your account for their equivalent value. If you sell all 100.5 shares of a stock worth $10, you’d receive $1,005 ($1,000 for 100 shares, and $5 for that dangling half a share). Keep in mind, some brokers may charge a fee to trade partial shares.
You give up some flexibility. Remember, DRIP reinvests a dividend back into the asset that paid you that dividend. So, if you want to keep some of that money in cash or funnel those dividends into a different investment, you’ll have to modify your DRIP strategy.
You still pay taxes on those dividends. Even though those dividends are invested immediately, they’re still considered income and taxed according to the rules in which the investment is held. Since the process is automated, you may not even notice all that dividend income which can lead to a surprise at tax time.
DRIP isn’t available on every investment. While DRIP is popular, it’s not universally available. Your brokerage firm or an individual stock may not offer automatic dividend reinvestment.
HOW TO SET UP DRIP IN YOUR PORTFOLIO
By default, your portfolio probably isn’t enrolled in a DRIP program. However, it’s pretty easy to get it started.
First, verify that your brokerage firm offers a DRIP, and see if any of your existing investments are excluded from that program. Check for additional eligibility criteria you’ll need to meet as well. While you may be able to participate in their DRIP, some brokers require you to own a minimum amount of an investment before you can sign up.
Keep in mind that each brokerage firm has its own process for enrolling in DRIP. You may need to submit a paper form, make a quick call to customer service, or simply enroll online.
And don’t forget to revisit DRIP if you buy a new stock or fund that wasn’t included in your portfolio when you first enrolled in DRIP. The asset may be swept into DRIP automatically, but you may need to take the extra step of enrolling that investment into DRIP.
No investment strategy can guarantee a profit or protect against loss.
Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.