DRIPs permit shareholders to use their dividends to purchase additional shares of the company’s stock.

Many investors who own stocks in companies that pay dividends do not need the dividend income to meet current expenses. Rather than receiving dividend payments and then having to take the time to reinvest them, many of these investors would prefer to automatically reinvest their dividends, purchasing additional shares of the company’s stock. The result is that many larger corporations usually offer their shareholders a dividend reinvestment plan. As the name implies, DRIPs permit shareholders to use their dividends to purchase additional shares of the company’s stock. The shares are purchased directly from the company thereby avoiding brokerage commissions.

Similarly, many companies have shareholder investment plans (SIPs) that permit investors to purchase shares of the company’s stock directly from the company, again avoiding brokerage commissions.

DRIPs – The Basics

To participate in a DRIP, you must own stock in a company that has a dividend reinvestment plan. Some DRIPs allow shareholders that own as few as one share of stock to participate while others require ownership of at least 50 shares. Log on to www.dripinvestor.com for a listing of companies that provide DRIPs.

Once you enroll in a DRIP your dividends are automatically reinvested into additional shares (or fractions of a share) of the company’s stock. For example, if you own one share of stock that has a $40 market value and pays a dividend of $2.50 per share, investing the dividend to purchase additional shares will result in the purchase of 0.0625 additional shares.

Total dividend reinvestment is not mandatory in many DRIPs; some plans permit “partial reinvestment.” Under the partial reinvestment option, investors may choose to reinvest some percentage of their dividends while taking cash for the remainder. The partial reinvestment option makes it possible for that investor to have the best of both worlds, reinvesting some of the dividends while also receiving cash dividends.

Companies offering DRIPs are required to provide the details and specific terms and conditions of their plan (including information on partial investment options) in a prospectus. Before you enroll, read the prospectus to be sure the fees, if any, are not unreasonable.

Advantages

One key advantage is that fees and brokerage commissions on purchases and sales made through DRIPs are designed to be considerably lower than the costs of dealing through a stockbroker. Furthermore, DRIPs can be ideal for investors who want to invest small amounts on a regular basis. Participation in a DRIP allows you to increase your ownership systematically, thereby dollar-cost averaging your investment over a period of years.

Many investors worry about financial confidentiality. Since a broker is not involved, DRIP investors need not discuss their investment objectives or financial position with a stockbroker or anyone else. Consequently, there is no pressure from anyone to trade. Finally, your stock certificates are typically held by the plan. Therefore, you do not have to worry about them being lost or stolen, or wonder where they are when you wish to sell the stock.

Disadvantages

All the dividends paid to you – whether issued by check or reinvested into additional shares of stock – represent taxable income to you in the year received. Therefore, one key disadvantage of DRIPs is the required payment of taxes on income that you do not actually receive. Furthermore, DRIP investing requires maintaining good records, especially to determine the cost basis of stock for tax purposes when you want to sell it. Companies and their transfer agents provide regular statements to help investors keep track of their DRIP holdings.

Finally, investing in DRIPs limits your flexibility to some extent. DRIP purchases are not executed as quickly as purchases available through a broker. The same is true when you want to sell. It may take five to 10 trading days for a sell transaction to be consummated. Consequently, DRIPs are suited for long-term investing and not trading.

It is important to note that investing in a company just because it offers a DRIP doesn’t make it a good investment. Consider the quality of the firm’s financial position, prospects for earnings growth over the next several years, dividend-growth potential, and the strength and defensibility of its industry position. These factors need to be assessed before making any investment.

The ideas presented here should be relied upon only when coordinated with professional tax advice.