Dividend reinvestment is a powerful strategy that can enhance your investment returns. By reinvesting dividends, you buy additional shares in the company or fund that paid the dividend, typically when the dividend is paid. Over time, this strategy helps you compound your gains by acquiring more stock and reducing your risk through dollar-cost averaging.

For instance, according to Dividend.com, an initial $2,000 investment in Pepsi in 1980 would have started an investor with 80 shares. Through dividend reinvestment, those shares would have grown to an impressive 2,800 by 2004, valued at over $150,000.

Here’s a breakdown of what dividend reinvestment is, how it works, and the pros and cons of this strategy.

What is dividend reinvestment?

Dividend reinvestment involves using the dividends you receive to purchase additional shares of your investments instead of spending the money. There are two primary methods to reinvest your dividends:

  1. Set up a dividend reinvestment plan (DRIP) directly with the company.
  2. Use your brokerage account to reinvest your dividends.

What is a DRIP program?

Hundreds of publicly traded companies offer dividend reinvestment plans, or DRIPs. These plans automatically reinvest the company’s dividends into new shares of their stock at each quarterly payout, often at no additional cost to you. The shares are purchased directly from the company rather than through a broker.

“For certain investors, especially those just beginning the investment process and looking for an easy ‘gateway’ to invest in individual stocks, DRIPs offer appeal,” says Chuck Carlson, editor of the DRIP Investor newsletter.

Some companies offer flexible options for DRIPs, allowing for full or partial reinvestment. Investors who want a steady cash flow can choose to have a portion of their dividends deposited into their checking or savings accounts instead of reinvesting the full amount.

Companies often allow investors to purchase fractional shares through DRIPs, enabling them to reinvest the entire dividend and compound their gains. Additionally, some companies offer DRIP shares at a discount to the current share price, providing a better deal than buying the same shares on the open market.

Dividend reinvestment with a broker

While the strategy of dividend reinvestment remains time-tested, investors no longer need to register with a company’s DRIP program to reinvest their money quickly and at a low cost. Many brokerages now offer free dividend reinvestment services, and with major online brokerages providing unlimited free trades, you can easily reinvest the dividends yourself.

If you’re reinvesting dividends with your brokerage, you can set up the account to automatically reinvest in shares of the company or fund that paid the dividend. This is a great alternative if your broker allows you to reinvest in fractional shares, enabling you to fully utilize your dividends.

Alternatively, you can have the broker leave the cash in your account and reinvest it in stocks that look attractive to you at the time. Either way, you’re reinvesting your dividends.

Cash vs. reinvested dividends

You have three broad choices of what to do with any dividends you receive:

  1. Hold the dividend as cash
  2. Spend the dividend
  3. Reinvest the dividend

Holding the dividend as cash or spending it is perfectly fine if you need the income. Investing in dividend stocks is a common way to generate income for retirees and others. However, by doing so, you won’t benefit from the advantages of dividend reinvestment and compounding.

If you reinvest in a growing dividend-paying company, you’ll likely benefit in two ways. First, you’ll profit if the stock price rises because you’ve added more shares to your stake. Second, if the stock’s dividends increase over time, you’ll own more shares, and each share will pay a higher dividend. This allows you to buy even more shares, creating a cycle of growth.

Dividend reinvestment can be a virtuous circle, creating a powerful dividend dynamo for you.

Pros and cons of dividend reinvestment

Dividend reinvestment shares many of the same advantages and disadvantages of regular investing but also has some unique pros and cons.

Advantages of dividend reinvestment

  • Compounding gains: Enjoy the benefits of compounding as your reinvested dividends add more shares to your portfolio.
  • Set it and forget it: Automatic reinvestment requires no further action once set up.
  • Easy setup: DRIP plans and brokerage reinvestment are simple to initiate and manage.
  • Avoid trading fees: Reinvestment plans may help you avoid trading fees, particularly with mutual funds.
  • Dollar-cost averaging: Lower your risk by reinvesting over time.
  • Flexibility: Pause or stop reinvestment as needed, or choose full or partial reinvestments.
  • Discounted stock purchases: Some DRIP plans offer stock at a discount.
  • Non-digital investing: DRIPs provide a mail-based alternative for those uncomfortable with online investing.

Disadvantages of dividend reinvestment

  • Minimum requirements: Some DRIPs require a minimum number of shares to participate.
  • Variable plans: DRIPs can differ significantly, so check specifics with the company, including any setup fees.
  • Limited to own stock: DRIPs only purchase their own stock, limiting diversification.
  • Inflexible reinvestment: Reinvestment happens when dividends are paid, not when you choose.
  • Potential for imbalance: Reinvesting dividends can lead to an overweight in dividend-paying stocks, reducing portfolio diversification.
  • Tax implications: Taxes on dividends are still due, requiring out-of-pocket payment.

Are DRIPS a good investment?

Given the evolving landscape of investment options and the rise of flexible, low-cost brokerage accounts, many experts now question the advantages of Dividend Reinvestment Plans (DRIPs) that were once highly regarded.

Stephen Taddie, a partner at wealth management firm HoyleCohen in Phoenix, notes, “The main benefit of a DRIP is that it sets up a regular reinvestment plan for cash distributions.” However, investing regularly is important not only because it prevents cash from idling but also because it leverages dollar-cost averaging to reduce risk by purchasing stock over time. Additionally, automating investments can be advantageous.

Robert R. Johnson, a finance professor at Creighton University, emphasizes, “Automating as many financial decisions as possible is beneficial. When we are automatically enrolled in a DRIP, our natural tendency toward inertia and laziness can work in our favor.”

Taddie explains that DRIPs were particularly valuable when transaction fees were prohibitively high. “Before the advent of online brokers, transaction fees were $300-$400 for round lots, which made DRIPs an appealing cost-saving strategy,” he says.

However, Taddie raises concerns about the traditional “set it and forget it” approach of DRIPs, particularly regarding the timing of reinvestment. “When stock prices are volatile, I’m not inclined to invest based on the calendar alone,” he notes.

Instead, you might prefer to accumulate dividends and invest in stocks at more opportune moments or diversify into different assets. “Using the total cash flow from dividends to purchase stocks with the most attractive prices or to diversify by adding quality stocks is often a better strategy,” Taddie concludes.

Getting started with dividend reinvestment

If you’re looking to start reinvesting dividends, you’ll need to choose between different types of reinvestment plans:

  • Brokerage Accounts: If you use a brokerage, you can reinvest dividends in both stocks and funds that pay dividends. Many brokerages also offer the option to invest in fractional shares.
  • Company DRIP Plans: If you use a company’s direct dividend reinvestment plan (DRIP), you can only reinvest dividends in that specific company’s stock.

Each brokerage has its own procedure for setting up dividend reinvestment, so you may need to consult your broker’s help site or customer support to get started. Generally, you can complete the setup process quickly online.

To initiate a DRIP account with a particular company, you can contact the company’s investor relations department directly. If the company does not offer a DRIP but pays dividends, you can still establish a reinvestment plan through your brokerage account.

Do you have to pay taxes if you reinvest dividends?

Regardless of whether you take your dividend payments as cash, reinvest them in stock, or do both, you are responsible for any taxes on that income. While this may not be a significant issue if you’re only receiving a few hundred dollars in dividends annually, it can become problematic if you’re receiving thousands and choose to reinvest the entire amount. You’ll need to cover the tax bill from other sources to continue reinvesting your dividends.

To address this, some advisors suggest placing dividend stocks in a tax-advantaged account, such as an IRA. This approach helps you avoid taxes on the dividends and allows them to compound more effectively.

In Conclusion

A company’s DRIP plan no longer offers the same cost benefits compared to a brokerage account, so those interested in reinvesting dividends might find it more advantageous to use their brokerage. However, if a company’s DRIP plan allows you to purchase stock at a discount to its market value, that can still be an appealing incentive.