How to Maximize Your Savings With Dividend Reinvestment Plans

If you have retirement savings accounts, college savings accounts or a brokerage account (maybe you’ve got them all), you likely 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. Below, we take a closer look at what DRIP means in investing, how it works, and how it could help you maximize the growth of your savings and investments over time.

What is DRIP in investing?

A dividend reinvestment plan is a program that investors can opt into so that, when they receive dividend payments from their investments, instead of being paid in cash, those dividends will automatically be used to buy additional shares of the investment. This means that the investor is always accumulating more shares—dollar-cost averaging over time and putting their money to work in the market.

How does DRIP work?

When you invest in stocks, there are two main ways that you can make money off of your investments. You can sell your shares for a higher price than you originally paid, pocketing the difference as profit. You can collect dividend payments from the stocks that pay them—or you can do both.

Companies that pay dividends to their shareholders typically do so monthly, quarterly, annually or even randomly (known as special dividends). Once they’re issued, you’ll get a small cut of cash for every share you own. 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 in the market for long-term growth and don’t need that cash for a number of years, 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 (or mutual fund, ETF, target-date fund, etc.). So, when the next dividend is issued, those additional shares that you just purchased will also earn dividends. If those dividends are reinvested again, you’ll buy even more shares the next time dividends are paid, which in turn may earn even more dividends next time. The cycle repeats until you decide to sell your shares or otherwise begin pocketing your dividends as cash.

Advantages of DRIP investing

There are several advantages to setting up a DRIP on one or more of your individual stocks:

No trading fees

Many brokers charge commissions or other trading fees each time you purchase (or sell) shares of a stock, mutual fund or ETF.

However, many brokerages waive those fees when your investments are purchased automatically through a DRIP. In some cases, purchases made through a DRIP actually give you access to discounted share prices—typically 1 to 10 percent below the market price. 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 lump sum. By spreading investments over a longer time frame, dollar-cost averaging empowers you to average out the price you pay for shares over time (rather than buying them all high or low). Over time, it can reduce the impact of volatility. A DRIP, by its design, helps you incorporate dollar-cost averaging automatically.

Purchase fractional shares

While many brokerages now allow investors to purchase fractional shares of an investment, that isn’t the case everywhere. If your brokerage doesn’t allow fractional investing, you’re required to buy whole shares when you invest—which can get tricky when you’re considering stocks with a high price tag. But a DRIP lets you own fractions of shares. So instead of waiting until you have enough cash to buy an entire share of stock, a DRIP buys you whatever full and fractional shares your dividends can purchase at the current price.

Downsides of DRIP investing

Just as there are benefits to DRIP investing, there are also potential drawbacks that you need to consider before embracing it as a part of your investment strategy:

Selling fractional shares

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, a 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—for example, by rolling money over into a different account—you’ll have to modify your DRIP strategy.

You still pay taxes on those dividends

While you won’t owe capital gains taxes unless you sell an investment for a profit, you may owe income taxes on any dividends you receive, depending on the type of account that the underlying shares are held in. Dividends received in a regular brokerage account, for example, are subject to income taxes. This is true even if you automatically reinvest the dividends using a DRIP. If you’re not careful, this could lead to a surprise tax bill come tax time.

A DRIP isn’t available on every investment

While DRIPs are popular, they’re not universally available. Your brokerage firm or an individual stock may not offer automatic dividend reinvestment. In this case, you’ll need a strategy for putting your dividend payments to use.

How to set up a DRIP in your portfolio

By default, your portfolio probably isn’t enrolled in a DRIP. 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 a 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 your DRIP if you buy a new stock or fund that wasn’t included in your portfolio when you first enrolled in a DRIP. The asset may be swept into the DRIP automatically, but you may need to take the extra step of enrolling that investment into it.

Signing up for a dividend reinvestment program is easy, but that doesn’t necessarily mean that it’s right for everyone. If you’re not sure whether or not a DRIP makes sense for you, your financial advisor may be able to help. In addition to evaluating the possible uses for your dividend payments, these professionals can also help you rebalance your portfolio when it becomes necessary to ensure you’re properly diversified and much more.

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.

Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP^®, CERTIFIED FINANCIAL PLANNER^®, and CFP^® (with plaque design) in the United States to Certified Financial Planner Board of Standards, Inc., which authorizes individuals who successfully complete the organization’s initial and ongoing certification requirements to use the certification marks.