Dividend reinvestment plans, or DRIPs, are widely used by investors who want to reinvest the quarterly cash dividend payment back into the company's stock. While the investor owes income tax on the dividend payment, the reinvestment takes place without incurring brokerage fees, and allows for the purchase of fractional shares.
From a tax perspective, the investor might prefer the company to retain earnings versus pay a cash dividend. When a company retains earnings instead of paying a dividend, the money is reinvested in the firm without triggering the tax event that a cash dividend triggers. The value of the firm goes up by the amount of the retained earnings.
When the investor reinvests the dividend through a DRIP program, all the money goes back into the firm, and the shareholder now owns more shares, but with the tax repercussions. Retained earnings are thought to be superior to dividend reinvestment when the investor wants to keep the money in the firm, according to financial theory.
So what should you do?
Seniors transitioning from work to retirement, and therefore from an accumulation portfolio to a retirement income portfolio to which they no longer contribute, may want to stop the DRIP in the portfolio.
This is especially true for the yield-hungry investors who overweighted dividend-paying stocks as an alternative to low yielding bank deposits and U.S. Treasury securities.
A retirement income portfolio needs to provide liquidity to the investor over time. While a total return investment approach considers capital gains equally with dividend and interest income, the decision to automatically reinvest dividend income can reduce investor choice in how that liquidity is achieved. That's especially true for the "never touch principal" investors who are unwilling to sell investments to raise funds.
That's why it makes sense to stop reinvesting the dividends and turn on the tap by using the dividends to generate income.
How did your views change about your portfolio when you started depending on it for income?
Read more about DRIPs.
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