What Is a DRIP Investment? Plus How It Works and Its Benefits

For investors seeking steady wealth-building rather than get-rich-quick schemes, dividend reinvestment plans (DRIPs) offer a methodical approach to growing investments over time. They come with built-in compounding that can greatly increase the size of your portfolio over the years and decades.

Many trading experts, including Yvan Byeajee, author of “Trading Composure: Mastering Your Mind for Trading Success,” argue that DRIPs can be a great part of a systematic approach that long-term investors need to succeed.

“Investing is about building wealth steadily over time. The key phrase is ‘over time,'” Byeajee told Investopedia. “Sustainable investing is about playing the long game, respecting the process, and allowing compounding to work its magic over time.” DRIPs embody this philosophy by automatically reinvesting cash dividends to buy additional shares of a company’s stock.

Key Takeaways

• Most investment experts and financial advisors suggest that most people benefit from a systematic, long-term way to build up their portfolios.
• A DRIP is one of these. It’s a dividend reinvestment plan through which cash dividends are reinvested to buy more stock.
• DRIPs use dollar-cost averaging (DCA), which is intended to average the price at which you buy stock as it moves up or down.
• DRIPs help investors accumulate additional shares at a lower cost since there are no commissions or brokerage fees.

Most major publicly traded companies like Johnson & Johnson (JNJ), The Coca-Cola Company (KO), and Procter & Gamble (PG) offer DRIPs either directly or through brokerage firms. These plans give investors a low-cost way to steadily increase their holdings without paying commissions or fees on reinvested dividends. DRIPs also help remove emotion from investing decisions since the reinvestment happens automatically, no matter the market conditions.

How DRIPs Work

A dividend is a reward to shareholders—often in the form of a cash payment via direct deposit. DRIPs allow investors the choice of reinvesting that cash in more shares of the company’s stock.

Many brokers allow you to reinvest dividends in the underlying securities through DRIP programs. However, you can also enroll in DRIPs directly with the company through direct stock purchase plans.

How Dollar-Cost Averaging (DCA) Works With DRIPs

“For most people in most situations, a long-term, buy-and-hold, diversified, low-cost investment approach is likely more suitable than active trading,” said David Tenerelli, a certified financial planner at Values Added Financial in Plano, Texas. “This is because it helps the investor ignore the ‘noise’ and instead focus on a disciplined approach.”

Tenerelli explained that one such strategy for long-term investing is dollar-cost averaging (DCA)—putting a set amount away periodically, no matter what. “It takes discipline to continue to buy investments during a market downturn, but a shift in mindset can help—rather than fearing financial loss, an investor can reframe it as buying stocks ‘on sale,'” he said.

DCA is a key feature of DRIPs. With DRIPs, your dividends automatically buy more shares when prices are low and fewer shares when prices are high. This means the dividends being reinvested are doing the work that most people with DCA strategies do by putting away a set amount of cash in an investment each pay period.

For example, suppose you receive a $100 quarterly dividend from a company. If the stock price is $50, your DRIP would buy two shares. But if the stock price drops to $25, that same $100 dividend would buy four shares. This automatic adjustment helps cut the risk of investing all your money when prices are at their peak and thus getting fewer shares in the long run.

Thus, the upshot of using DCA in DRIP programs is that it turns market volatility from your enemy into an ally, automatically buying more shares when prices dip.

Important

Experts like Byeajee and Tenerelli advise combining DCA with DRIPs because it removes more of the emotional element from investing. “It takes discipline to continue to buy investments during a market downturn,” Tenerelli said. “But a shift in mindset can help—rather than fearing financial loss, an investor can reframe it as buying stocks ‘on sale.'”

Types of DRIPs

Company-sponsored and brokerage-operated DRIPs offer different paths to reinvesting your dividends. Understanding the differences can help you choose the option that best fits your investment style and goals.

Company-Sponsored DRIPs

These let you buy stock directly from companies like Coca-Cola or Johnson & Johnson, often at a discount of 3% to 5% below market price, our review of such plans available online showed. DRIPs typically let you start with a small investment—sometimes buying even one share—and then make additional purchases over time.

Many companies go out of their way to make such plans seem like you’re joining a special club where you get special perks—which you do, including discounted shares and zero commission fees.

But why do companies do this? Simple: They get investment dollars or capital from shareholders, which they can use to reinvest and grow the company. In addition, investors who are part of a company’s DRIP program are believed to be less likely to sell their shares if the company has one bad earnings report or if the overall market declines.

Brokerage DRIPs

Brokerage DRIPs work differently. If you already have an account with Fidelity, Charles Schwab, etc., you can typically enroll any dividend-paying stocks you own in their DRIP program. While you won’t get the company discount, these plans offer more flexibility since you can easily manage all your investments in one place and quickly turn the DRIP feature on or off for different stocks.

Most investors start with brokerage DRIPs because they’re convenient and don’t require setting up separate accounts with each company. However, if you plan to invest regularly in a specific company over many years, a company-sponsored DRIP will save you more money in the long run.

The Benefits of Using DRIPs

Beyond automatic reinvestment, DRIPs offer several advantages that make them attractive for long-term investors. The most obvious benefit is the 3%-to-5% discount we mentioned above.

But DRIPs also help enforce investment discipline. When dividends are used to automatically buy more shares, you’re less likely to spend that money elsewhere.

Perhaps most importantly, DRIPs harness the power of compounding. Each reinvested dividend buys more shares, which then generate larger dividend payments, which then buy even more shares. Over time, this snowball effect can significantly increase your total returns.

Potential Drawbacks to DRIPs

While DRIPs offer many benefits, they’re not right for everyone.

Math With Fractions

Since dividends are typically less than the price of company shares, you’ll be buying fractional shares over time. For example, let’s say that Company X pays a $10 dividend on a stock that traded at $100 per share. Every time there’s a dividend, those within the DRIP plan would receive one-tenth of a share.

Since you’re buying fractional shares at different prices over time, calculating your cost basis for taxes can become complicated—imagine tracking hundreds of tiny purchases over many years. That said, whether you use a DRIP through the company or your brokerage, your DRIP account will likely take care of this, keeping detailed records of your share ownership percentages for you.

You’ll Need Patience

DRIPs also require patience and a long-term perspective. This is because, even if something comes up that requires you to sell your shares quickly, company-sponsored DRIPs can slow this process down since you typically must sell through the company rather than through a broker.

Diversification

In addition, too much of a focus on dividend-paying stocks might lead to a less diversified portfolio. Not all great companies pay dividends—for example, many growth stocks like technology companies reinvest their profits rather than paying dividends.

The problem becomes even more acute if you use company-sponsored DRIPs since you might limit yourself just to one or two companies, putting a far greater part of your portfolio in just one part of the market.

Tax Implications of DRIPs

Even though you’re reinvesting rather than receiving dividends in cash, the IRS still considers the dividends as taxable income in the year they’re paid out. Just like if you take your paycheck and put it right into a savings account, you still owe taxes on that income even if you never touch the money.

For regular dividend-paying stocks held in taxable accounts, these dividends are typically counted as qualified dividends, which are taxed at lower long-term capital gains rates rather than as ordinary income. However, you’ll need to meet certain holding period requirements to qualify for these lower rates.

In addition, when you eventually sell the DRIP shares, you’ll owe capital gains taxes on any appreciation in share value. This is where good record-keeping becomes crucial—you’ll need to know your cost basis (purchase price) for all those shares bought through your DRIP over the years.

Can I Participate in DRIPs If I Buy Stocks Through My Individual Retirement Account (IRA)?

Yes, you can enroll stocks held in IRAs and other retirement accounts in DRIPs. One advantage of reinvesting dividends in retirement accounts is that you won’t face any immediate tax consequences on the dividends, unlike in taxable accounts.

However, any dividends automatically reinvested still count toward your required minimum distributions once you reach the age when these become mandatory.

What Happens to My DRIP Investments If the Company is Acquired or Merges With Another?

There are a couple of possibilities. If the acquiring company has a DRIP, your enrollment might transfer to the new company’s plan. In cash buyouts, your DRIP typically ends and you receive cash for your shares. In stock-for-stock deals, your shares usually convert to the shares of the acquiring company. It’s important to read all communications from the company during these transitions since you may need to decide what happens to your DRIP account.

How Do Stock Splits Affect DRIPs?

When a company splits its stock, your DRIP should shift over seamlessly. For example, in a two-for-one split, you’ll now own twice as many shares at half the price, but the total value of your account will be the same.

Future dividend reinvestments will simply buy shares at the new split-adjusted prices. The main impact is that you might be able to buy more whole shares with each reinvestment since the share price is lower.

When Is a DRIP Not the Best Choice?

DRIPs might not suit investors who rely on dividends for income since reinvesting them takes away the cash you might need to be available. In addition, investors focused on maintaining a diversified portfolio may find DRIPs concentrate their investments too heavily on a single stock or handful of stocks. In these cases, manually reinvesting dividends in other securities might be more appropriate.

The Bottom Line

DRIPs offer a great way to build a portfolio over time, especially if you get a discount on the shares along with the effects of compounding. While DRIPS require patience and careful record-keeping, the potential long-term benefits often outweigh these challenges.

Just remember to consider both the advantages and limitations of these plans in the context of your overall investment strategy, risk tolerance, and tax situation.