A DRIP isn’t what your faucet does at 2 a.m., and it’s not your dorky neighbor. It’s a financial acronym; it stands for “Dividend Reinvestment Plan.”
Here’s how it works. Say you’re a starving twentysomething living in a three-flight walkup and you’re eating Ramen noodles three times a day. But you don’t plan to be starving in your old age – you’re going to save for retirement! You’d like to invest in a big, safe, blue-chip company that pays good dividends and that’s going to be around 100 years from now. After researching several possibilities, you choose XYZ Corporation. However, XYZ is trading at $50 a share. At that price, you can afford to buy a grand total of one – count ‘em! – one share.
Here’s where a dividend reinvestment plan really comes in handy. Let’s say, for example, that you call XYZ Corporation directly and tell them you want to enroll in their dividend reinvestment plan. You buy one share of XYZ from the company and register it in your name to become a shareholder of record. You fill out a DRIP application, you read the company prospectus. Boom – you’re enrolled in the XYZ DRIP.
At the end of the next financial quarter, you receive a statement. It informs you that your one share of XYZ stock has earned a dividend of $1, which was automatically reinvested. You now own one share of XYZ, plus a fractional amount of a second share. You weren’t charged anything for this fractional purchase.
This process repeats itself every quarter. Your XYZ dividends are reinvested in new, fractional purchases. Over time, they start to add up to whole numbers. Soon you own two shares of XYZ, and three, and four, and five. This process is called compounding, and it’s amazing how it adds up.
However, if you want to speed things up, you can also invest fresh money in the DRIP through an Optional Cash Purchase Plan. Plans vary by company: you check and see that XYZ doesn’t charge you any fee to make an additional cash purchase of stock, and that you can invest as little as $15.
Say three months later you get a raise at work and you’re able to go a bit further. You arrange to have $25 a month automatically transferred to your DRIP. You’re now buying $25 worth of XYZ a month -- even though XYZ is selling for $50 -- and since you’re buying direct from the company, you aren’t being charged stock commissions.
What’s more, you’re now dollar-cost averaging. Dollar-cost averaging just means that because you’re buying stock every single month, you don’t have to worry about whether the price of XYZ was high or low at the time. You’re buying every month, both when it’s high and when it’s low, so in the end, the price averages out for you.
Some companies even allow DRIP investors to buy additional stock at less than the market price!
So far, a rosy picture. But are there any drawbacks to owning DRIPs?
Some people complain that DRIPs can be inconvenient come tax time. When you sell your shares, you have to report the cost basis when calculating capital gains tax, and that’s a pain. Then too, a company you want to buy from might not offer a DRIP. If they do, the fees for setting one up may be high, or a minimum purchase amount may be required. Stock gurus also advise investors to diversify their DRIP holdings over several companies and market sectors to minimize risk. If you take their advice, it will be inconvenient to sign up for, and keep track of, six or seven separate DRIP programs through seven different companies.
Be aware that DRIP arrangements also vary based on the company. Some companies don’t want to manage DRIPs in-house and farm that work out to transfer agents, such as banks. In that case you would have to apply to the bank to enroll, though in many cases you may do this online. You may also purchase DRIPs through brokerage firms, and since brokerages keep good account records that are useful at tax time, some DRIP owners prefer the convenience of purchasing them this way. However, keep in mind that while brokerages may allow you to reinvest your dividends, they won’t allow you to purchase additional stock through an Optional Cash Purchase.
To recap: if you have more time than money, and want to start a retirement fund, a dividend reinvestment plan can be a good way to build a nest egg. Just be sure to diversify, and keep track of your activity. And if you want to make additional stock purchases as well as just reinvest dividends, buy directly from the company, or from its transfer agent, since brokerages do not offer this option.
Related article: Free DRIP brokerage firms in 2012
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