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Dividend reinvestment is an attractive strategy that can juice your investment returns. With dividend reinvestment, you buy more shares in the company or fund that paid the dividend, typically when the dividend is paid. Over time, dividend reinvestment can help you compound your gains by buying more stock and reducing your risk through dollar-cost averaging.

For example, according to Dividend.com, an initial $2,000 investment in Pepsi in 1980 would have started an investor with 80 shares. By using dividend reinvestment, those shares would have numbered an astonishing 2,800 in 2004, worth more than $150,000.

Here’s what dividend reinvestment is, how it works and the pros and cons of the strategy.

What is dividend reinvestment?

Dividend reinvestment is plowing the dividends you receive back into your investments rather than spending them. You have two major ways to reinvest your dividends:

  • Set up a dividend reinvestment plan – a DRIP – directly with the company
  • Use your brokerage account to reinvest your dividends

What is a DRIP program?

Hundreds of publicly traded companies operate what are called dividend reinvestment plans, or DRIPs. Like the acronym, they drip the company’s dividend into new shares of their own stock at each quarterly dividend payout. Companies run these programs without any ongoing cost to you. The shares are purchased directly from the company, rather than through a broker.

“For certain investors, especially those just beginning the investment process and looking for an easy ‘gateway’ to invest in individual stocks, DRIPs offer appeal,” says Chuck Carlson, editor of the DRIP Investor newsletter.

Some companies offer flexible options for DRIPs, like full or partial reinvestment. Those who want a steady flow of money into their checking or savings account can opt to have a portion of dividends go there instead of reinvesting them in full.

Often companies permit investors to purchase fractional shares, allowing them to roll their entire dividend into new stock and helping to compound their gains. And some companies even offer DRIP shares at a discount to the current share price, getting you a better price than if you had bought the same shares on the open market.

Dividend reinvestment with a broker

While the strategy of dividend reinvestment remains time-tested, investors no longer need to register with a company’s DRIP program to reinvest their money quickly and at a low cost. Many brokerages will do it for free now, and with major online brokerages offering unlimited free trades, you can simply reinvest the dividends yourself, too.

If you’re reinvesting dividends with your brokerage, you can set up the account to automatically reinvest in shares of the company or fund that paid the dividend. This is a great alternative if you use a broker that allows you to reinvest in fractional shares since you can put all your money to work.

Alternatively, you can have the broker leave the cash in your account and you can reinvest it in the stocks that look attractive to you at the time. Either way, you’re reinvesting your dividends.

Cash vs. reinvested dividends

You have three broad choices of what to do with any dividends you receive:

  • Hold the dividend as cash
  • Spend the dividend
  • Reinvest the dividend

Either holding the dividend as cash or spending it are fine to do if you need the income. Investing in dividend stocks is a typical way to generate income for retirees and others, after all. But if you do so, you won’t enjoy the advantages of dividend reinvestment and compounding.

If you reinvest in a growing dividend-paying company, you’ll likely win in two ways. First, you’ll profit if the stock price rises because you’ve added more shares to your stake. Second, the stock’s dividends are likely to rise over time if it’s successful. So you’ll own more shares and each share will pay a higher dividend, which buys you even more shares and so on.

Dividend reinvestment can be a virtuous circle, creating a powerful dividend dynamo for you.

Pros and cons of dividend reinvestment

Dividend reinvestment offers many of the same advantages and disadvantages of regular investing but also has some additional pros and cons.

Advantages of dividend reinvestment

  • Enjoy compounding gains. If the stock continues to rise over time, you’ll enjoy the benefits of compounding, as you add money to your stock.
  • Set it and forget it. If you set up your account to automatically reinvest dividends, you don’t have anything else to do. The plans typically run until you tell them to stop.
  • Easy to set up. DRIP plans and reinvesting at your brokerage are easy to set up and manage.
  • Avoid trading fees. While few online brokers have trading fees now, you may be able to dodge fees at a mutual fund, if you enable automatic dividend reinvestment.
  • Lower risk through dollar-cost averaging. By reinvesting over time, you’ll take advantage of dollar-cost averaging and lower your risk.
  • You can put reinvestment plans on pause if you need the cash or discontinue them entirely. Or if you’re using a DRIP, you can make full or partial reinvestments. You can also pile up cash in your brokerage account and reinvest it yourself if you prefer.
  • Possibility to buy stock at discount. Some DRIP plans may allow you to buy stock directly from the company at a discount.
  • Alternative to investing online. DRIPs may also be valuable for those who won’t invest using an online broker. “There is still an investor populace that is uncomfortable investing online and would rather do it via the mail,” says Carlson. “DRIPs offer a way for those folks to invest.”

Disadvantages of dividend reinvestment

  • May require minimums. While DRIPs are designed to help small investors, the companies may require a minimum number of shares to participate in the plan.
  • Plans may vary. Because DRIPs may vary substantially, it’s important to contact the company to find out the specifics of its plan. For example, some companies may require a one-time fee to set up an account. A company’s investor relations department will have info on the plan, and then you can determine whether it meets your needs.
  • DRIPs invest only in their own stock. DRIPs buy only their own stock or fund. So if you want to use your dividend payment to buy a different stock, you’ll have to do it yourself.
  • Inflexible reinvestment schedule. DRIPs and reinvestment with a broker generally reinvest at the time a dividend is paid, so investors don’t have flexibility on when they reinvest. Another stock may have better profit potential than the stock that paid the dividend.
  • May lead to an unbalanced portfolio. If you have stocks that pay dividends and others that don’t, you may wind up with overly large positions in your dividend stocks. That can reduce diversification and make your portfolio more reliant on those bigger positions.
  • Still must pay taxes on dividends. You may reinvest your whole dividend, but you’ll still have to come up with any taxes on the income. And that means you’ll have to pull money out of your pocket to foot the tax bill.

Are DRIPS a good investment?

Given some inflexibility in DRIP plans and the flexibility and low cost of brokerages these days, many experts don’t see the same advantages of DRIP plans that they once did.

“The only benefit from a DRIP that I can see is you establish a regular reinvestment program for cash distributions,” says Stephen Taddie, partner at wealth manager HoyleCohen in Phoenix.

Investing regularly is important, and not only because reinvesting keeps cash from sitting idle in the account. Reinvesting also allows you to take advantage of dollar-cost averaging, reducing your risk by purchasing stock over time. Plus, you can turn your laziness into an advantage.

“People should try and automate as many financial decisions as they can,” says Robert R. Johnson, professor of finance at Creighton University. “If we are automatically enrolled in a DRIP, inertia and the inherent laziness of people tend to work in our favor.”

“DRIPs made sense when transaction commissions were at cripplingly high levels,” says Taddie. Taddie points to the days before online brokers when brokers charged much more. “It is hard to imagine $300-$400 transaction fees for round lots… but that is the world that created the allure of DRIP programs. It was a cost-saving mechanism,” he says.

Taddie notes another issue with traditional “set it and forget it” dividend reinvesting — the assumption that you’ll want to buy the stock exactly when the dividend is paid, the typical time that companies and brokers reinvest dividends.

“The more volatile the price of the stock, the less interested I am in letting the calendar mandate when to invest more money in a company,” he says.

Instead, you could save up the cash from your quarterly dividends and put it to work in a stock that’s attractively priced when you want and not when the reinvestment plan mandates. It may make more sense to reinvest it in a different asset with a different risk and return. And that’s not an option offered by DRIPs, where you can buy only the company’s stock.

“The combined cash flow received from a quarter’s worth of dividends could be used to buy one of those stocks whose price is the most attractive, or, to increase diversification and add another good quality stock,” says Taddie.

Getting started with dividend reinvestment

If you want to start reinvesting dividends, you’ll need to decide which type of reinvestment plan you want to use:

  • If you work through your brokerage, you’ll be able to reinvest in both stocks and funds that pay dividends, and many brokerages let you invest in fractional shares.
  • If you work through a company’s DRIP plan, you’ll be able to invest and reinvest in only that company’s stock.

Each brokerage account has its own process for setting up dividend reinvestment, so you may need to refer to your broker’s help site or customer support to start reinvesting. But typically, you can complete everything online quickly.

To start a DRIP account with an individual company, you can directly contact investor relations at the company. If the company doesn’t offer a DRIP program but pays dividends, you can still set up a reinvestment plan with your brokerage account.

Do you have to pay taxes if you reinvest dividends?

Whether you take your dividend payment as cash or reinvest in stock (or both), you’re still on the hook for any taxes on that income. That may not create a huge problem if you’re receiving a few hundred dollars in dividends a year. But it can become problematic if you’re receiving thousands and decide to reinvest all that money into stock. You’ll have to come up with the cash to pay the tax bill from other accounts so that you can maintain your dividend reinvestment.

That’s why some advisors may recommend that you stash dividend stocks in a tax-advantaged account such as an IRA. It’s one way to avoid taxes on the payouts and let them compound.

Bottom line

A DRIP established at a company doesn’t offer the same cost benefits over a brokerage that it used to, so those looking to reinvest dividends are probably better off turning to their brokerage. Still, if a company’s DRIP plan lets you buy stock at a discount to its market value, that can be an attractive incentive.