The Benefits of DRIP and How To Use It

The following is a guest post from Dan@StockTrades.ca

Dividend stocks at one time or another will more than likely become the backbone of your investing portfolio. Especially in your later years, the passive income from your dividend investments can play a pivotal role in your retirement. But if you are a young aspiring investor with a keen eye on early retirement, what is the best thing to do with that dividend check? In my honest opinion, it’s setting up a DRIP plan.

So what exactly is a DRIP plan?

A DRIP, or dividend reinvestment plan is a system set up by your broker,company or financial institution to purchase more stocks with your dividend payouts. The shares are purchased in fractions if your dividend payout is not enough to purchase a whole share. The best way to imagine this is a bucket stopping a leak. Every time water “drips” into the bucket, it fills. Once the bucket is full, you’ve earned a share in that company. You dump the bucket out, and repeat the process.

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To DRIP or Not To DRIP

Dividend Reinvestment plans (DRIPs) are investment programs run by publicly traded companies to invest in them and provide shareholders with partial shares reinvested back in the company instead of paying out cash dividend each quarter (or whatever the dividend schedule is). This is advantageous to the companies since they can keep the money in the company where it can be put to good use while providing investors in more stake of the company through the share reserve. Companies usually run these programs through a Transfer Agent or a Brokerage firm. This article takes a look at the overview of the DRIP program and the various advantages and disadvantages to investors using this methodology.
When investing via DRIP, there are couple of terms used liberally and I want to include them here as I use them in the article below. A Share Purchase Plan (SPP) allows you to buy more shares in the company in the future.  This is usually a recurring event that you setup with the Transfer Agent or Broker. An Optional Cash Purchase (OCP) is a one-time optional purchase of more shares in the company. 
The following are the advantages and disadvantages of the DRIP program.

Advantages of DRIP

  1. Commission-free: Enrolling in the DRIP program does not cost the investor any money. The program is sponsored by the company and so, there are no brokerage fees or transaction fees to worry about.
  2. Partial shares: Investors can choose a certain dollar amount to contribute by enrolling in the SPP or using the OCP to buy partial shares in the company. When dividends are scheduled, partial shares from the reserve are allocated instead of distributing the dollar amount.
  3. Faster Reinvestment: This point is best illustrated by comparing synthetic and full DRIP. Synthetic DRIP is the DRIP supported by most discount brokers, where the dividend amount needs to cover a whole share. Full DRIPs, on the other hand, work with partial shares as well. The advantage of Full DRIP is that money gets reinvested immediately, even with partial shares, and investor’s money can be put to work effective immediately.
  4. Discounts: Some companies provide discounts for registering in the DRIP program. These discounts can vary anywhere between 1-5%, which means higher dividend rate and yield-on-cost on your overall returns.
  5. Dollar Cost Averaging: Enrolling in SPP or using OCP offers investors with the opportunity of taking advantage of dollar cost averaging. This is one of the cornerstones of long term investing and you are able to build your equity slowly.

Disadvantages of DRIP

  1. Setup Effort: Setting up the program and getting started takes a lot of time and effort. Also, getting your first share and setting up is confusing for starters which deters people from enrolling in these programs.
  2. No Control on Stock Price: Due to the way the payment structures are setup with SPP  or OCP, the investor can only choose the amount of money invested and has no control of the price paid on the stock. The Transfer Agent or Broker simply takes the closing market price of the stock on the date it chooses to execute the plan.
  3. Where’s the money? If you depend on and need to withdraw income from your investments, DRIP programs do not work out, as you don’t actually see the money. All you get is more equity in the company.
  4. Taxation: Although listed as an advantage by a lot of writers (due to dividends being taxed favorably), taxation can be a double-edged sword. I consider taxation more of a disadvantage than an advantage due to the fact that there is no tax-shelter when investing using a DRIP program. Consider all the taxation involved when investing via DRIP – (a) the companies pay out their dividends after it has paid its due taxes, (b) you are investing in the company after paying your income taxes, (c) you pay taxes on the dividends received, and (d) you pay taxes on the capital gains. If the money was invested in registered accounts instead, you would be sheltered from some of the taxes mentioned earlier.
The taxation point is a big thorn for me personally. Even though I have a DRIP account with one company – The Bank of Nova Scotia (BNS), I am not convinced that DRIP programs are that great. Do you think there is any value in DRIPping outside tax-sheltered accounts (even with the DRIP discounts)?
To learn more about DRIPs, go to DRIP Primer and DRIP Investing.
Disclosure: I am long BNS. See my full list of holdings here.