The pros and cons of dividend reinvestment plans
Disclaimer: The below article is for informational purposes only and does not constitute a product recommendation, or taxation or financial advice and should not be relied upon as such. Please check with your adviser or accountant to obtain the correct advice for your situation.
Dividend reinvestment plans or DRIPs (DRPs in Australia and New Zealand) allow investors to reinvest their cash dividends to purchase new shares in a company. DRPs allow for direct acquisition of shares from the company itself, sometimes at a discount to the market value, and involve no brokerage fees. While these benefits might sound like a good reason to partake in the scheme, there are some things to keep in mind before deciding to partake in a DRP.
This article will cover:
- How DRPs work
- Pros of dividend reinvestment plans
- Cons of dividend reinvestment plans
- Taxes and dividend reinvestment plans
How DRPs work
Before jumping into the advantages and disadvantages of dividend reinvestment plans, here’s an example of how they work:
- Let’s say you own 1,000 shares in company X.
- You have chosen to participate in its DRP so that 100% of your dividends are reinvested.
- The company announces a dividend of 15 cents per share.
- The shares have a market value of $10.50 each.
- You would normally receive $150 in the form of a cash dividend (1,000 x $0.15).
- However because you’re enrolled in the DRP, you receive 14 shares (14 x $10.50 = $147), which increases your total holding to 1,014 shares.
- Because the remaining $3 isn’t enough to buy a share, the amount is carried forward to the next dividend payment.
Pros of dividend reinvestment plans
Taking the above into consideration, there are a number of advantages that DRPs offer investors, including:
No brokerage fees
Reinvested dividends enable the acquisition of new shares/stocks with no brokerage fees. This makes for a very cost-effective method for buying new shares over time. Not having to pay brokerage fees can make a big difference, especially for small trades, as they are one of the main expenses for investors which eat into returns.
Dollar cost averaging
Dollar cost averaging is a strategy where investors buy the same amount of shares on a regular interval, building savings and wealth over a long period. DRPs incorporate a similar idea, with your money being regularly reinvested back into the same company, and gradually growing your holdings. At times, the shares will be purchased when they are overvalued, and at other times when they are undervalued. However it should even-out over time. As a result, investors will have less tendency to make an emotional buy/sell decision, as they have a set strategy in place.
Sometimes DRPs offer new shares with a discount to the market price. These discounts can range from 1 - 5% and can be a great incentive to partake in a DRP.
Capital management tool for companies
DRPs also benefit companies, as they utilise the scheme to retain capital, paying dividends in the form of newly issued shares. As a result, the company maintains its capital, which can then be reinvested back into the business for future growth.
Simplifies the investment process
DRPs appeal to “set-and-forget investors”, as they can simplify their investing strategy by automatically reinvesting their dividends in new shares. This makes it very easy to grow their portfolio without needing to spend much time or attention on their investments.
DRPs can be considered a form of forced or passive saving as you don’t ever personally receive any of the dividend money, therefore cannot be tempted to spend it.
Grows your portfolio value incrementally, providing the benefit of compounding as each time a DRPs is offered, you will receive a larger number of shares than the previous time (if dividend payouts are unchanged).
No lower limit
There is no lower limit on the number of shares that are required to be owned by an investor, meaning all investors are eligible and able to benefit from dividend reinvestment plans.
Cons of dividend reinvestment plans
Now that we’ve covered the positive aspects of DRPs, let’s look at the reasons many investors avoid DRPs.
No control over price or time
Investors who partake in a DRP do not have any control over the time and price that the shares are purchased, as they are automatically “purchased” on the dividend payout date. This means that you could be buying when the shares are very expensive (although the reverse could be true too – see “dollar cost averaging”, above). Over a long period, this effect usually balances out, being no better or worse off. For less sophisticated investors who don’t continually monitor and try to predict share prices, this will make little difference. However, for more advanced investors, this is considered a significant drawback.
Unbalanced portfolio allocation
Registering for an automatic DRP can be an attractive way to grow your investments. However, this can lead to your portfolio being heavily weighted in certain areas, and unbalancing your target portfolio allocation. Therefore, it is essential to monitor your portfolio allocations, rebalancing them as necessary.
For many investors, dividend income is used to initiate new positions in different shares. However, in DRPs, dividend payouts are directly reinvested back into the same company, potentially preventing the establishment of new holdings and thus leading to a lack of portfolio diversification over time.
Not suitable for short-term investors
DRPs are not suitable for short term investors as purchasing the shares on the market is much faster compared to obtaining shares through a DRP. This is especially true for stocks that pay dividends quarterly or bi-annually, rather than monthly. Therefore, it is often much better for shorter-term investors to take the cash dividend and purchase shares separately.
No income stream
As DRPs require sacrificing cash in exchange for new shares in the company, it removes the stream of income that is associated with dividend payments. For a retiree or someone who depends on dividends to support their living expenses, this strategy is not ideal.
Dilution of ownership
DRPs dilute the ownership for an investor in a company as new shares are issued, meaning to maintain the same level ownership, more shares need to be purchased. A maximum level of participation may be introduced to reduce this dilutive effect, discouraging institutional shareholders from participating.
Tedious record keeping
DRPs require both the share purchase price and dividend payment amount to be recorded each time for every dividend payment. This can be very painful to keep track of, especially with a large portfolio. However this portfolio admin problem can be easily solved by using a dedicated portfolio tracker such as Sharesight. For more info, see: How to track a dividend reinvestment plan.
Sharesight makes it easy to keep track of DRPs/DRIPs
Taxes and dividend reinvestment plans
As per the ATO, for capital gain purposes, DRPs are treated as if you had received the dividend and then used it to purchase additional shares. Franking credits are dealt with in exactly the same manner. If you received a discount, it is not considered taxable income at the time of purchase, rather it is included in the CGT at the time of sale.
When selling shares that have been issued through a DRP, the cost base for the CGT is determined by the market price of the shares at the time of purchase. This is the true price paid for the shares, including any discounts to the share price, which your CGT will be based on.
If a Canadian investor chooses to take part in a DRIP, their ordinary taxable dividend is subject to the gross-up (for Canadian companies) and dividend tax credit provisions that is faced by all dividends. The new shares that have been acquired through a stock dividend are deemed to have been acquired at a cost equal to the stock dividend amount. When selling their investment, the CGT is applied where the difference between the adjusted cost base (ACB) and the net proceeds received is considered a capital gain or loss. Investors partaking in a DRIP within a tax-free RSP or TFSA account don’t have to worry about this, but those investing in taxable accounts may want to read this article on the tax treatment of Canadian dividend paying stocks.
As per the IRS, if you choose to reinvest your dividends in a DRIP, the IRS treats this as two different events. First, the dividend is treated as taxable income, with no difference from a regular dividend payout. Second is the share purchase and future sale where the capital gains will be later taxed.
Some U.S. companies also allow for investors to purchase additional shares of a stock at below market price, in this case, the cash reinvested, and the fair market value of the stock are taxed as ordinary dividend income.
Simplify your portfolio tracking with Sharesight
Sharesight was built for investors like you, and makes it easy to keep track of your portfolio. Here’s how:
- Automatically track share prices and dividends (including DRPs/DRIPs).
- Get the true picture of your investment performance, including the impact of brokerage fees, capital gains, dividends, and currency fluctuations with Sharesight’s annualised performance calculation methodology.
- Run powerful tax reports, including the Capital Gains Tax Report (Australia and Canada), Traders Tax Report (NZ) and foreign investment fund income FIF Report (NZ).