What Is a DRIP Investing Plan?

Dividends are like the side dishes in investing: Investors either ignore them or base their whole meal on them. Whether you pay attention to them or not, dividends can be an effective means of growing wealth over time with a dividend reinvestment plan, or DRIP.

What is a DRIP plan? Rather than letting dividends accumulate in cash or a money market account, a dividend reinvestment plan automatically uses the dividends you earn to purchase more shares of your investment.

Many investors underestimate the power of DRIP investing, says Andrew Crowell, vice chairman of D.A. Davidson & Co. Wealth Management in Los Angeles. They look at the minuscule dividends they earn and think something so small can’t have a significant impact. But in the butchered words of Shakespeare, “Though the dividend be but little, it is fierce.”

Take AT&T Inc. (ticker: T) for example: Today, T stock is yielding about 6 percent and trading at just over $32. This amounts to $1.92 per share in annual dividends. If you own 100 shares of T, you’d receive $192 in dividends per year. By reinvesting those dividends, you’d have 106 shares by the end of the year.

This means the following year your dividend payout is based on 106 shares, netting you $203.52 in annual dividends. Reinvest again and you’d buy yourself another 6.36 shares of T, increasing your position to 112.36 shares.

If the company also increases its dividend each year, “you could be getting a raise every year plus the compounding effect [of reinvested dividends] for doing nothing other than letting the DRIP work for you,” Crowell says. Couple that with capital appreciation from a rising stock price and it’s easy to see how DRIP investing can be a “winning formula.”

[See: 7 Dividend Stocks Yielding 7 Percent and More.]

The benefits of DRIPs. Being able to buy fractional shares is one area DRIPs shine. There is no way to buy 0.36 shares of AT&T on the open market, but with a DRIP you can. This ensures you’re always fully invested.

And as an added bonus, you typically get to buy those shares commission-free. A necessary perk if you’re buying only 0.36 shares because no one wants to pay a $7 trading commission for $11.52 worth of stock.

Even better: DRIPs make investing automatic. Similar to an employer 401(k), with DRIP investing, money is being added to your account at regular intervals without you needing to do anything.

By automating investing, DRIPs take the behavioral decision-making biases we all have out of the equation, says Amanda Agati, co-chief investment strategist at PNC Financial Services Group in Philadelphia. They ensure you continue to invest and reinvest even when falling stock prices make you fearful.

“That’s actually a healthy behavioral approach,” she says, because it means you’ll be buying at lower prices.

If the share price falls, your dividend will buy more shares. As dollar cost averaging demonstrates, this typically results in a lower average cost per share.

[See: 7 Mistakes to Avoid With Dollar Cost Averaging.]

Drawbacks of DRIP stock investing. Removing the emotional component to investing is a perk, but automation can also be a drawback to DRIP investing.

With automatic reinvestment, “you’re buying shares of a stock that at any given point of time might be overvalued or undervalued,” Agati says. You lose the ability to determine if the price is an appropriate entry point.

“Because it’s an automatic investment program, [a DRIP] could be accumulating additional shares of your most overvalued stocks at a time when you’d rather be accumulating shares of your most undervalued stocks,” Crowell says. Doing so could unbalance your asset allocation and cause you to unwittingly increase your risk profile.

For this reason, DRIP investing isn’t a set-it-and-forget-it strategy, he says.

You still owe taxes on your dividend. Another potential drawback to DRIPs, albeit a minor one, is that dividends received in a taxable account are considered taxable income, even if you reinvest them. Since you don’t receive cash proceeds from reinvested dividends, you could end up with a tax bill at the end of the year that needs to be settled, Agati says.

DRIP investing also complicates cost basis tracking. If the stock pays quarterly dividends, you’ll have four additional tax lots of reinvested dividends each year.

For any shares purchased with reinvested dividends, your cost basis is the proportional amount of the dividend. So if your $50 dividend bought two shares of stock, your cost basis for those shares is $25 per share. And the date the dividend was paid becomes the holding date.

“Most firms help investors with cost basis tracking, but it simply means there are more moving parts to track,” Crowell says.

DRIPs can trigger wash sales. Of greater concern to the tax-loss harvesting DRIP investor may be wash sales. The wash-sale rule states that you cannot deduct losses from the sale of an investment if you purchased the same or a substantially similar investment within 30 days of the sale.

This applies both forward and backward: If you purchased the security 30 days before the sale or buy it 30 days after the sale, your losses are disallowed.

“Even a fractional DRIP share purchase will nullify” the loss, Crowell says. Say you wanted to sell AT&T at a loss to offset other capital gains. If AT&T paid you a dividend less than 30 days ago or pays you a dividend within 30 days from the date of your sale and your DRIP reinvests that dividend, the IRS won’t let you claim the loss.

The best way to handle the wash-sale rule is to take the stock off its DRIP for the 60-day window around the date you plan to sell, Crowell says, because companies can declare special dividends that are off-cycle from their quarterly payouts.

How to choose DRIP stocks. “The ideal DRIP would be a total return story where you’re getting stock price appreciation and dividend growth over time,” Agati says. To achieve this, look for a healthy company with a history of paying and increasing its dividend. Companies like those on the dividend achievers list, which have increased their dividend for at least 10 consecutive years.

But almost any investment can be placed on a DRIP, be it a stock, mutual fund or ETF, provided the investment and your broker allow it.

Use DRIP investing as one tool in your toolbox. As with all areas of investing, DRIP stock investing should only be used within a diversified portfolio.

[See: 7 Blended ETFs to Own for a Diversified Portfolio.]

“This can be an effective tool but it should not be used in isolation,” Agati says. “Some of the best investments may not even pay a dividend.”

More from U.S. News

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7 Monthly Dividend Stocks for Steady Income

8 Simple Rules for Investing in Retirement

What Is a DRIP Investing Plan? originally appeared on usnews.com

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