Dividend Reinvestment Plans (DRIPs or DRIP plans) are popular products for investors who wish to take advantage of compounded dividends, often (but not always) low fees, and easy-to-execute investing.
This is how it works:
- DRIPs are offered either through brokers or directly from the dividend-paying company.
- When a dividend is distributed, it is automatically reinvested in the same company’s stock at the market rate (sometimes at below-market prices, depending on the terms of the DRIP).
- The investor then will earn dividends on the new shares purchased, and that benefit is compounded over time.
But, while the benefits are easy and easy to understand, the downsides are more complex and therefore get overlooked without solid advice. Here are several things to be aware of if you are invested in a DRIP plan:
- You could be losing passive income – If you are retired and drawing from your investments for income, then dividends offer you an easy source of cash that is taxed at the long-term capital gains rate.
- Might not be the right thing to buy – Because DRIP plans are automatic, you could be buying shares in a company that’s overvalued and missing opportunities in assets that are undervalued when dividends just happen to be distributed.
- Potential for overconcentration – DRIPs are recommended for long-term investing, but if you don’t pay attention, the steady purchase of more shares in the same company can mean you are overinvested in one stock or sector.
- Dividends are a taxable event – While this is not a problem peculiar to DRIPs, some critics note the inefficiency of receiving money from an investment, paying taxes on it, then returning it to the asset. You will want to consider the tax implications of any dividend if your investments are not protected within a retirement vehicle.
- Not every company that offers dividends is a good DRIP candidate – DRIP investing is not recommended for short term investing in risky companies. It is best done with predictable businesses that have proven themselves over decades.
- Be aware of fees – You may pay fees for moving your dividends electronically and triggering the reinvestment buy orders. If you are working through your broker, make sure they explain exactly what fees will and won’t be taken to execute your DRIP.
Like all investing, the best strategy is knowledge and good advice and that is why investors turn to financial advisors and brokerages. If you feel like you’ve been placed in investment plans that do not fit your needs, or have received bad advice that benefited your broker, Contact Rose Law to find out if you have been the victim of stockbroker or brokerage firm misconduct.