How dividend reinvestment works
Friday, October 3, 2008
Are Drips Worth It?
This article originally appeared on The DIV-Net September 26, 2008.
The abbreviation DRIP stands for dividend reinvestment plans. Drips are a nice low cost way to purchase dividend stocks and build a stock portfolio. These programs allow investors to purchase shares in two ways either through reinvesting dividends or with optional cash payments that can be sent to the companies you want to invest in. One benefit of drips is that they allow dividend reinvestment in partial shares. Another benefit of other drips is that some allow reinvesting your dividends by purchasing shares at a discount to the market price. Two such companies that I am aware of that do this are ACAS and NNN. Below you can also check my analysis of ACAS and NNN .
One of the issues with drips is that in order to participate in the DRIP you must already have purchased one share of the company stock. Some companies have overcome that hurdle for shareholders by letting people make a direct purchase in their stock. Stocks like GE or XOM are good examples of direct purchase plans with reinvestment plans.
Another problem with drips however is that you do not have the execution speed like you do when you purchase shares through a broker. If you want to buy or sell shares at the current market price, you can’t do it. In addition to that, despite the fact most drip plans allow charge low or no fees for purchasing additional shares or reinvesting your dividends, most drips have high initial set-up fees.
Another issue that I have with drips is availability. Not all companies offer drips, so you might have to use a stock broker after all.
From a tax perspective drip Investors must track their cost of shares to be used to calculate capital gains tax when shares are sold. In addition to that very few dividend reinvestment plans allow you to hold stocks in an IRA DRIP, which allows for a tax
free compounding of your dividends. Examples of non-taxable dividend reinvestment plans include XOM. which offers both traditional and ROTH IRA dividend reinvestment plans.
From a diversification perspective a drip investor has to enroll in as many plans as the number of individual companies he or she plans to invest in. This would a be very inefficient way to keep track of your investments.
The main positive of drips is the fact that one can start with a small amount of money, typically enough to buy one share of stock. DRIPs also allow novice investors to dollar cost average small amounts of money each month without getting killed on the brokerage commissions. The automatic dividend reinvestment comes in handy as if allows you to simply set up your drip with a company and then its all automatically invested into additional shares, while you take full advantage of the power of compounding.
So what is a good alternative to dividend reinvestment plans?
Most brokers allow you to purchase stock in any company that is traded on the NYSE, NASDAQ, AMEX and the OTC markets by charging you a small commission for that. After that however most brokerages do not charge any additional fees if you decide to reinvest your dividends. Some brokers like Sharebuilder allow you to reinvest your dividend by purchasing fractional shares, which accelerates the power of compounding in your favor. In addition to that, I would prefer having my entire dividend portfolio concentrated in one or two places as opposed to having it spread out among thirty different reinvestment plans. Most brokers also keep much more detailed information of your transactions activity in one place, compared to drip plans, which definitely helps during tax time.
And last but not least it is much easier to open a retirement account at a stock broker for a small fee, without being limited to the small number of drips inside an IRA out there.
DivGuy and Get Rich Slowly have both published some insightful articles on DRIPs. Check them out.Source: www.dividendgrowthinvestor.com