What Are Dividend Reinvestment Plans?

When you own stock in a firm that pays dividends, you can choose to have those dividends reinvested instead of receiving them as cash. Dividends are paid to stockholders by many companies. You reinvest your dividends to buy more company stock when you reinvest them.

Is Dividend Reinvestment good or bad?

Dividend reinvestment is a popular approach for increasing investment returns. Dividend reinvestment entails purchasing additional shares of the firm or fund that paid the dividend at the time it was paid. Dividend reinvestment can help you compound your returns over time by allowing you to acquire additional shares while lowering your risk through dollar-cost averaging.

What is dividend reinvestment, how does it operate, and what are the benefits and drawbacks of the strategy?

What are the advantages of a dividend reinvestment plan?

When you reinvest dividends, instead of taking the cash, you use the money to acquire more stock. Dividend reinvestment is a smart technique since it allows you to do the following:

  • Reinvestment is free: When you acquire more shares, you won’t have to pay any commissions or other brokerage expenses.
  • While most brokers won’t let you acquire fractional shares, dividend reinvestment allows you to do so.
  • You acquire shares on a regular basis—every time you earn a dividend, for example. This is a demonstration of dollar-cost averaging (DCA).

Because of the power of compounding, reinvesting dividends can boost your long-term gains. Your dividends let you buy more stock, which raises your dividend the next time, allowing you to buy even more stock, and so on.

Which is better growth or dividend reinvestment?

The total investment value in the IDCW reinvestment plan is lower than the Growth Plan due to the impact of tax on dividends and TDS.

When the dividend announced is less than Rs. 5,000 and your total taxable income is less than Rs. 5 lakh per year, your IDCW Reinvestment Plan returns will be the same as the Growth Plan. There will be no TDS in this situation, and you will not have to pay any tax on your payout. As a result, the IDCW Reinvestment Plan will have the same amount of money reinvested as the Growth Plan.

Both the IDCW Reinvestment and Growth plans reinvest the mutual fund scheme’s returns in order to gain higher returns and take advantage of compounding.

The main difference between the Growth Plan and the Dividend Reinvestment or IDCW Reinvestment plans is that the Growth Plan is more tax-efficient. So, if you want to reinvest your money and benefit from compounding, you don’t have to jump through the hoops of Dividend Reinvestment or IDCW Reinvestment. Instead, use the Growth Plan to automate the reinvestment process. That’s all there is to the solution.

Is Drip good for stocks?

The nicest part about DRIP investing is that it’s a powerful instrument for automating your investments. Because DRIP investing is a hands-off technique, it’s perfect for stocks that are of such excellent quality and low risk that you don’t need to pay attention to them all that much.

Is DRIP investing worth it?

DRIP schemes run by companies allow investors to buy stock directly from the company, and dividends are automatically reinvested in the stock, sometimes at below-market prices.

The two most evident advantages of dividend reinvestment are: You can enhance your position for no cost and automatically, so you don’t have to think about it. Dividend reinvestment is a terrific passive approach to enhance your exposure over time if you own a high-quality stock for a long time. You might collect the dividends and manually invest them somewhere else, but a healthy habit that requires no effort is easier to maintain than one that requires some effort.

However, the third and least obvious reason to reinvest profits is actually the most potent. It’s compounding’s potency, which is what makes compound interest so potent.

Reinvesting dividends increases the size of your investment and, as a result, the dividends you’ll receive in the future. As a result, each reinvestment will be slightly larger than the previous one (provided dividend payments remain constant). You’ll be shocked how quickly those small additions pile up, just like compound interest!

Let’s imagine you hold 100 shares of a $40 stock that pays a 2.5 percent dividend. This translates to $1.00 per share in annual dividends, or 25 cents per quarter. This chart depicts how your dividend income and investment size will change over the first year.

Because you now possess another $25 worth of dividend-paying shares, reinvesting the first $25 boosts your second dividend payout by 16 cents. Your quarterly payouts have climbed to $25.47 by the end of the year, and the value of your investment has increased by $100.94—that $100 is merely the dividend payments, which you would have received whether you chose to reinvest or not. However, the extra 94 cents are “dividends on dividends,” which you earned by reinvesting your dividends.

Ninety-four cents may not seem like much, which is why time is the second most crucial factor at play. Your yearly dividend income from this stock will be $126.31 after ten years, up from $100.94 the first year. (Based on your initial investment, that’s a 3.16 percent yield on cost.) Without any stock price gain, the value of your investment will be $5,132.11. Your dividends on dividends contributed $132 and 11 cents to that total. (If you hadn’t reinvested, the value of your investment would have remained at $4,000, and you would have received $1,000 in dividends, totaling $5,000.) Dividends on dividends are the difference between that and $5,132.11, which we’ll call dividends on dividends.)

Your investment will be worth $8,448.26 after 30 years, and you’ll be collecting $207.95 in dividends every year—you’ve more than doubled your initial income and are getting a 5.2 percent yield on cost.

All of this has happened without a single increase in the stock price or dividend. If you invest in a Dividend Aristocrat that raises its dividend every year, your returns will improve year after year. If the corporation in the example above increases its dividend by 5% per year, your yearly income will be $200 after ten years, rather than $30 after thirty. Your annual income will be $2,218.83 after 30 years, and your investment will be valued $22,022.24. Not bad for a stock that doesn’t increase in value.

Of course, if you buy a stock that increases in value over the period of 30 years (as most do! ), you’ll be even happier. While your reinvestments will be at higher prices, the capital gain on your new shares will more than compensate. (If you’re curious, look up a dividend reinvestment calculator online and enter some figures.)

The Case Against DRIP Plans

While dividend reinvestment is advantageous, there are a few reasons why you would not want to do it.

The most obvious reason is that you require financial assistance. Dividends are an excellent source of passive income if you’re at the “distribution” stage of your investing career. The long-term capital gains rate applies to income from qualifying dividends (currently 15 percent for investors who are in the 25 percent to 35 percent tax bracket for ordinary income, 0 percent for taxpayers in a lower bracket and 20 percent for those in the highest bracket). It makes sense to have that money deposited in your account if you’re going to be turning to your portfolio for revenue every month anyhow.

For allocation reasons, you can decide to stop reinvesting your income. Reinvesting dividends, whether through DRIP programs or otherwise, will grow your stock positions over time, and if you’ve owned a particular company for a long time, it may already represent a significant portion of your portfolio. Higher-yielding holdings will increase more quickly, which can potentially throw your allocations out of whack. So, after a stock holding has grown to the size you want it to be (for the time being), you may turn off dividend reinvestment and either enjoy the extra income or save the money to invest in other stocks.

Finally, you may not want to reinvest dividends for stock-specific reasons, such as if a stock is momentarily overvalued or you simply don’t want to acquire more of it at present pricing.

However, reinvesting dividends through a broker or directly through dividend-paying firms’ DRIP plans is a surprisingly strong instrument for passively improving your investment returns. Yes, DRIP plans are worthwhile if they align with your investment objectives.

Why you should not reinvest dividends?

When you don’t reinvest your earnings, your annual income rises, changing your lifestyle and options dramatically.

Here’s an illustration. Let’s imagine you put $10,000 into XYZ Company, a steady, well-established company, in 2000. This enables you to purchase 131 shares of stock for $76.50 each.

As a result of stock splits, you will possess 6,288 shares by 2050. It’s presently trading at $77.44 a share, giving your entire holding a market value of $486,943. You’ll also get $136,271 in dividend checks over the next 50 years. Your $10,000 became $613,214 thanks to your generosity.

While not enough to replace a full-time wage, your dividends would give a significant amount of additional revenue in this instance. It might be used for unexpected expenses, vacations, or education, or simply to augment your current income.

Additionally, you would end up with $486,943 in shares in your brokerage account. This could result in a considerable increase in dividend income. It may also provide a significant amount of your retirement income.

Do reinvested dividends get taxed?

When you acquire stocks, you may be eligible for monthly cash payments known as dividends, which firms choose to deliver to shareholders in order to attract and keep investment. Cash dividends are taxable, but they are subject to special tax laws, so the tax rate you pay may be different from your regular income tax rate. Dividends reinvested are subject to the same tax laws as dividends received, therefore they are taxable unless they are held in a tax-advantaged account.

Do you pay fees on reinvested dividends?

The Dividend Reinvestment Plan (DRIP) allows you to reinvest your cash dividends1 from your equity assets automatically. On the dividend distribution date, RBC Direct Investing purchases shares2 in the same firms on your behalf. There are no fees or commissions to pay.

How do I avoid paying tax on dividends?

You must either sell well-performing positions or buy under-performing ones to get the portfolio back to its original allocation percentage. This is when the possibility of capital gains comes into play. You will owe capital gains taxes on the money you earned if you sell the positions that have improved in value.

Dividend diversion is one strategy to avoid paying capital gains taxes. You might direct your dividends to pay into the money market component of your investment account instead of taking them out as income. The money in your money market account could then be used to buy underperforming stocks. This allows you to rebalance your portfolio without having to sell an appreciated asset, resulting in financial gains.

Are reinvested dividends taxed twice?

After filing my 2010 tax return, I’m sorting my tax records. You advised keeping year-end mutual fund records that indicate reinvested dividends in How Long to Keep Tax Records so that you don’t wind up paying taxes on the same money twice. Could you please elaborate?

Sure. Many taxpayers, we feel, get tripped up by this dilemma (see The Most-Overlooked Tax Deductions). The trick is to maintain track of your mutual fund investment’s tax base. It all starts with the price you paid for the initial shares… and it expands with each successive investment and dividends reinvested in more shares. Let’s imagine you acquire $1,000 worth of stock and reinvest $100 in dividends every year for three years. Then you sell the whole thing for $1,500. To calculate your taxable gain, deduct your tax basis from the $1,500 in proceeds at tax time. You’ll be taxed on a $500 gain if you just report the original $1,000 investment. However, your true starting point is $1,300. Even though the money was automatically reinvested, you get credit for $300 in reinvested dividends because you paid tax on each year’s payout. If you don’t include the dividends in your basis, you’ll wind up paying tax twice on that $300.

Do reinvested dividends count as TFSA contributions?

If you’re worried about going overboard with your TFSA contributions, check your contribution room and don’t deposit more than that.

Another Financial Geek post, How Can I Check My TFSA Limit?, explains how to check your current TFSA contribution room step by step.

Avoid giving more than this amount until January 1st of the following year.

Quick Note #2 – TFSA over-contributions are subject to a 1% monthly penalty tax.