DRIP: dividend reinvestment plans

In short

A friend of mine once told me his dividends were "just sitting there," and he did not like the feeling. If you own shares of a company that pays dividends, a dividend reinvestment plan, called a DRIP, can turn each payment into more shares instead of cash. You can ask your broker or the company's transfer agent whether a plan is offered for your shares. You can also ask whether it charges fees and whether fractional shares are allowed. Reinvested dividends are still taxed in the year they are paid, even though no cash reaches your hand. Good records of each reinvestment will help at tax time. That small bit of paperwork saves a lot of headaches.

The whole of it

What it is

I once watched a neighbor plant a few seeds from last year's tomatoes instead of buying new ones. A DRIP works a bit like that. A company pays a dividend, which is a share of its profit sent to its owners. Instead of mailing you the cash, the plan uses it to buy more shares, and sometimes slivers of a share, for your account.

If you are holding shares of a company, you may find two kinds of plans. One is run by the company itself, often through a transfer agent, which is a firm that keeps the list of who owns the shares. The other is run by your broker, who offers to reinvest dividends on many of the stocks in your account. Both do the same basic job. A company's plan may let an owner buy shares straight from the company. A broker's plan simply buys shares in the market for the owner.

You have probably heard this called compounding. That is a fancy word for a plain idea. Your new shares earn dividends too, and those dividends buy still more shares. It is a slow snowball.

How it works

A friend of mine signed up for a plan and was surprised that nothing seemed to happen on the day he enrolled. That is normal. The action comes later, on the payment date, when the company pays its dividend. The plan takes your cash, divides it by the share price, and adds the result to your holdings.

If you are holding shares that cost $40 each, picture a dividend of $20. The plan buys half a share, because $20 divided by $40 is 0.5. Many plans allow fractions like this. Some do not, and they pay out the leftover cash instead. The plan documents will say which rule applies.

A few company plans sell new shares at a small discount to the market price. When that happens, the plan documents state the percent. Most plans sell at the full price, so a discount is something to check, not something to assume.

Fees vary. Some plans charge nothing. Others take a small fee per purchase, or charge when shares are sold. The plan's fee schedule lists every charge. Read it before you enroll.

You also keep control. A reinvestment election is usually something the owner can turn on or off. If you want the cash again, you tell the broker or the agent, and the next dividend arrives as money. Check how far ahead of the payment date your request must arrive. Missing that date means one more round of reinvestment.

The numbers, and where to find yours

If you are wondering what to look up, start with your dividend rate. Your brokerage statement shows each dividend and the shares it bought. The company's investor relations page lists its dividend history and its plan documents. For fees and discounts, the plan documents are the place to look. A company plan describes its terms in a plan prospectus or similar document, and the exact form depends on how the plan is set up. The transfer agent or the investor relations page can send a copy.

Taxes need their own spot here. The IRS treats reinvested dividends as income in the year they are paid. Your broker reports them on Form 1099-DIV. Whether a dividend is taxed at the ordinary rate or at a lower qualified rate depends on rules set by law. The current rate brackets are published by the IRS at irs.gov, and the qualified dividend rule is explained in IRS Publication 550, Investment Income and Expenses. The holding period needed for a dividend to count as qualified is the current figure, which the official source publishes each year, and the income thresholds for each rate tier are the current figure, which the official source publishes each year.

One more number matters a great deal. Each reinvestment creates a new purchase with its own cost. That cost is your basis, which is the amount you paid, and you use it to figure your gain or loss when you sell. Most brokers track this for you. A company plan may leave the tracking to you, so keep every statement.

A worked example

Let me tell you about a woman named Marcy. She owns 100 shares of a company priced at $50 a share. Her holding is worth 100 times $50, which is $5,000. The company pays $2 per share each year, so her yearly dividends are 100 times $2, which is $200.

Marcy turns on reinvestment. Her first $200 buys shares at $50 each. That is $200 divided by $50, or 4 new shares. She now holds 104 shares.

Next year the company still pays $2 per share. Her dividends are 104 times $2, which is $208. At $50 a share, that buys $208 divided by $50, or 4.16 shares. She now holds 108.16 shares.

I noticed something small when I first ran these figures. Year one brought 4 shares. Year two brought 4.16. The difference is tiny, but it grows.

For simplicity, Marcy's share price never moves in this story. Real prices rise and fall, and so do dividends. The company can also cut its dividend or stop it. Nothing here predicts what will happen to her account.

Now the tax side. Marcy pays tax on the $200 in year one, though she never touched the cash. If her tax rate on dividends is 15 percent, which is only an example, the tax is $200 times 0.15, or $30. She must find that $30 from her paycheck or savings, because the plan used every dollar of the dividend to buy shares.

I once helped a cousin sort out her records, and the same lesson applies to Marcy. Her basis is what she paid. The first 4 shares cost $200, or $50 each. The next 4.16 shares cost $208, or $50 each. If she sells all 108.16 shares at $50, the sale brings in 108.16 times $50, which is $5,408. Her basis is $5,000 for the original shares, plus $200, plus $208, which is $5,408. Her gain is $5,408 minus $5,408, or $0. Without those records, she might report the whole sale as profit and pay tax twice on the same money. Tax twice. Nobody wants that.

Where it goes wrong

I once knew a fellow who ignored his statements for six years. When he finally sold, he could not say what he had paid. That is the most common trouble with a DRIP. The plan is easy to start and easy to forget.

Taxes catch many people off guard. The dividend is income even when it buys more shares. Set aside money for the bill, or you may feel squeezed in April.

Concentration is another quiet risk. A DRIP keeps adding shares of one company. Over the years, that company can grow into a large share of your savings. If it stumbles, your whole account can feel it. Nothing in this guide says whether to hold more or less of anything. It simply points out that a plan on autopilot keeps buying the same stock, whatever the price.

Watch the fees too. A small fee on every purchase can eat a large part of a small dividend. Look at the fee schedule and do the arithmetic. If a plan charges $2 on a $20 dividend, that is $2 divided by $20, or 10 percent, gone before a single share is bought.

Last, remember that plans can change. A company may end its plan or change its terms. The plan documents explain how that works and how participants are told about a change.

Questions to answer before you leave this page

Have you looked at whether your broker or the company runs the plan, and do you know who keeps your records? Do you know whether the plan buys fractional shares, and what it does with any leftover cash? Have you read the fee schedule and worked out what each purchase costs in dollars? Do you have a plan for paying the tax on dividends you never received in cash? Are you saving every statement so your basis is clear on the day you sell? Do you know how to turn reinvestment off, and how far ahead of the payment date the request must arrive? And have you looked at how much of your savings already sits in this one company?