The Perks Of Dividend Reinvestment Plans

Dividend Reinvestment Plans, or DRIPs, are a way for shareholders to reinvest variable amounts in a company over the life of a long-term investment. By reinvesting dividends, shareholders can purchase shares or fractions of shares (if the dividend amount is less than the value of one share) of some of the most well-known publicly-traded companies for as little as $10 at a time. Instead of giving the investor a quarterly dividend check, the entity running the DRIP (the company, transfer agent or brokerage firm) uses the money to purchase additional shares of the company in the name of the investor.

If the company itself is operating the DRIP, it will set specific times in the year (usually quarterly) when the purchase of shares by shareholders in its DRIP program is allowed. The company itself does not go into the secondary market and purchase the shares and then sell them through the DRIPs. The shares sold through the DRIP are taken out of the company's share reserve. DRIP shares cannot be sold on the market; when investors are ready to sell their DRIP shares, they must sell them back to the company that issued them at the current market price.

If the DRIP is operated by a brokerage firm, the firm simply purchases shares for you from the secondary market and adds the shares to your brokerage account, and these shares are eventually sold back on the secondary market.

1. Company-operated DRIPs are commission-free because there is no broker required to facilitate the trade. This feature is very appealing to small investors, who otherwise would have to save up funds for an extended period of time in order to make the typical brokerage commission fee a small enough proportion of their purchase amount.
2. Some DRIPs offer optional cash purchase of additional shares directly from the company, usually at a 1-10% discount and with no fees attached.
3. DRIPs are flexible by nature. Investors are able to invest large or small amounts, depending on their financial position. Some DRIPs allow investors to contribute as little as $10 or as much as $500,000 at one time.
4. DRIPs use a technique called dollar-cost averaging — averaging out the price at which you buy stock as it moves up or down over a long period. Using this system, you are never buying the stock right at its peak or at its low. (For further reading, see Financial Concepts: Dollar-Cost Averaging and DCA: It Gets You in at the Bottom.)

You may be wondering why a huge company would concern itself with selling a couple of shares here and there. For the company, the advantage is that DRIPs offer low-cost access to capital. When you purchase a stock on an exchange, you are buying it from another investor, so the company sees no benefit from the sale. DRIPs are different. The DRIP shares are bought directly from the company and the proceeds are then reinvested into the company.

Companies also like DRIPs because they encourage a stable shareholder base that typically has a long-term investment style. DRIP investors are unlikely to run for the exits when the markets start to sour, partly because DRIP shares are less liquid than shares in a regular brokerage account or shares in the secondary market. Selling them takes a little more time and effort than just calling a broker. Remember, if the shares come from a company-operated DRIP, they need to be repurchased by the company — this does not allow for the kind of easy sales found in the general stock market.

Due to the increasing popularity of this investing technique, more and more companies are setting up DRIPs, but not all plans are set up and run in the same manner.

1. Companies that operate the DRIPs themselves will have their investor relations department handle all aspects of the plan, sometimes even allowing individuals to buy a share of the company (to start a DRIP account) directly from this department as opposed to from a broker.
2. While some companies run their own plans, others find the costs too great and use third parties, or transfer agents, who act on behalf of the company and handle all of the company's DRIP details.
3. A third alternative for investors is a DRIP set up through a brokerage. Because not all companies have a dividend reinvestment plan set up, some brokerages will recognize this void and allow investors to reinvest dividends at no cost, essentially simulating a DRIP. However, be aware that these brokerage-run plans only allow for the reinvestment of dividends and offer no cash purchase option. Also keep in mind that brokerages are out to make a buck too, and they will only provide this service for customers who also use their account to make commissioned trades.

Starting a DRIP account requires a little legwork from the investor. First off, you must research which companies have DRIPs, as not all do. However, there are many companies that do offer DRIPs (excluding brokerage run DRIPs). The internet offers great resources for finding which firms have DRIPs and what the terms of these accounts are.

Once you know that your desired company has a dividend reinvestment plan, you must determine who runs the plan — the company or a transfer agent? Next, you'll have to buy shares in the company to be able to set up the account.

In order to qualify for a DRIP, the shareholder is often required by the company that operates it to have his or her name registered on the stock certificate. Shares held in a brokerage account are very rarely registered in the shareholder's name and are instead registered in street name. This cuts down on the company having to phone brokerage firms to confirm ownership.

The specific characteristics of DRIPs can vary from company to company. For example, some companies allow shareholders to buy shares based only on their dividends, while others allow optional cash purchases on top of the dividend reinvestment. Make sure you do your research before signing up for a DRIP.

With a company-operated DRIP, the shares are issued from the company's own reserve of shares. When investors want to sell any shares purchased through a DRIP, they can only sell them back to the company. For this reason, a DRIP that is operated by the company itself does not affect the stock price of the shares in the market.

Conversely, a DRIP operated by a brokerage account purchases its shares directly through the secondary market. Because these shares are both bought and sold at market prices, a brokerage-operated DRIP will have the same effect on stock prices as a normal buy or sell transaction in the open market.

Another misconception about DRIPs is that they are not subject to tax, because the investor is not receiving a cash dividend per se. In fact, while DRIPs are beneficial for their cost-effective approach to investing, they are still subject to tax. Because there was an actual cash dividend, although reinvested, it is considered to be income and thus taxable.

Also, as with any stock, capital gains from shares held in a DRIP are not calculated and taxed until the stock is finally sold, usually several years down the road.

(For more, check out Capital Gains Tax 101.)

DRIPs have a number of traits that benefit investors and companies alike. Being familiar with how DRIPs work and participating in a plan can bring increased value to your portfolio.

(For further reading, see How and Why Do Companies Pay Dividends?)