DRIPs, or dividend reinvestment plans, are arrangements in which cash dividends from your investments are automatically reinvested in more shares. In certain instances, enrolling in a DRIP makes reinvesting cash dividends easier and even less expensive. However, before enrolling in a DRIP investing, it is crucial to understand how it operates, the benefits and downsides they offer, and how to enroll in a DRIP.
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What Exactly Is DRIP Investing?
Genuinely, DRIPs are programs that automatically reinvest dividends into more shares. You must choose to join a DRIP; participation in these schemes is voluntary. Depending on your broker, you can have various DRIP investing alternatives.
Working Principles of DRIP Investing
As an example of how DRIPs operate, suppose you own 300 shares of a corporation that pays a dividend of $1 per share. Through your brokerage business, you have joined a DRIP program. You will receive $300 when the corporation distributes dividends.
Assume that when you get the dividend, the stock’s share price is $25. Instead of receiving $500 in cash, you would receive 20 more shares of stock.
Fractional shares are exactly what their name implies: fractions of a complete share. Therefore, holding 1.65 shares of a stock is feasible instead of one or two. What if the price of the stock in our scenario was $26? Five hundred dollars would purchase 19.23 shares of stock. You would acquire 19 shares valued at $494. However, the fractional share may be treated differently by various brokerage houses. In rare instances, the fractional share might be purchased for 19.23 shares.
Pros and Cons of DRIP Investing
- Low commissions
- Timely reinvestment
- Dollar-cost averaging
- Insufficient diversification
The business may waive the commission on most reinvested dividends if you set up a DRIP with a brokerage firm. This will result in a greater proportion of your funds being invested in more shares. However, not all brokerage firms provide DRIPs commission-free, so verify with yours.
Due to the automated reinvestment of dividends into more shares, DRIPs lessen the risk of leaving funds uninvested if you neglect to do it manually. Uninvested cash in an account might diminish profits over time.
By reinvesting dividends automatically, you will automatically practice dollar-cost averaging. Dollar-cost averaging implies the recurrent purchase of an investment instead of a single lump-sum investment. The average purchase price can be reduced by purchasing more shares at regular intervals.
If you establish a DRIP plan for a single stock, you may collect a substantial quantity of that stock over time, diminish your diversification, and expose yourself to unnecessary risk.
Be advised that if you engage in a DRIP with a taxable account, you will still be required to pay up to 20% in taxes on the reinvested profits. The primary concern is ensuring you have the funds to pay the tax on time. Otherwise, you may be required to sell a portion of your shares to obtain the cash.
How to Start a DRIP Investing
When you buy an investment via your broker, you can enroll in a DRIP by selecting the option to reinvest dividends. Alternatively, you may phone your adviser, if you have one, and have them assist you through the process.
In short, a dividend reinvestment plan (DRIP) formed by a corporation no longer offers the same economic advantages over a brokerage as it once did. Thus, consumers seeking to reinvest dividends are likely better off using their brokerage. Nonetheless, if a company’s DRIP plan allows you to purchase shares at a discount to their market value, this might be an enticing inducement.
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Source: The Balance