Dividend reinvestment plans, or DRIPs, have historically been a low-cost way for individual investors to build their stock holdings. About 1,000 companies offer DRIPs, which automatically use dividends to purchase more shares. You can participate by buying a single share to start with.
DRIPs are a good option for people who don't need cash flow from their dividend-paying stocks and want to build their investment over a long time frame. They're often used by investment clubs to grow their portfolios. And they provide an excellent way to learn about stock investing.
"Many grandparents use the programs to introduce their grandchildren to investing, and match whatever the youngster has contributed," says Martha Schilling, an investment adviser in suburban Philadelphia. If the DRIP is being opened for a child, the relative who does so might be able to give the initial share as a gift so the child can start at little or no cost.
You can open a DRIP by purchasing one or more shares through a broker or, in some cases, directly from the company. The latter lets you avoid paying a brokerage fee. If you buy your initial shares through a broker, you'll need to transfer them to the company that manages the DRIP. (You might incur a transfer charge.) Some DRIPs reinvest the payouts into fractional shares at no cost to you and let you buy additional shares directly with no commission. Others charge fees for those services. For a list of no-fee DRIPs go to directinvesting.com.
You can also create a "synthetic" DRIP within a brokerage account. The advantages and convenience of that option might outweigh the commissions you'll pay when you buy the initial shares and make any subsequent investments. For one thing, you won't be limited to companies that have formal DRIPs; many brokers, including Fidelity, Schwab, and TD Ameritrade, will reinvest any stock dividends at no cost. And commissions are as low as $12 a trade at discount brokers, so the cost of buying shares isn't outrageous.
Otherwise, if you have several directly held DRIPs, you'll get statements from each one. And during tax season, you'll get 1099s from each program. By contrast, if you hold them in a brokerage account, all the tax information will be consolidated on one form. Either way, you'll owe tax on the dividends that are reinvested.
When you sell shares in traditional DRIPs, you'll need to figure out your cost basis—the purchase price plus fees and commissions, and accounting for stock splits and other adjustments—to determine your taxable gain or loss. This can be complicated for long-held shares with years of reinvested dividends. Under a new law, brokerages must provide investors with cost-basis information for stocks and exchange-traded funds bought in 2011 or later on IRS Form 1099-B. In 2012, the rule extends to DRIPs. But this new rule doesn't apply to investments you already own.
Another reason to hold dividend-paying stocks in a brokerage account is that you'll be able to monitor them better and integrate them into your overall investment strategy. "DRIP programs usually end up being forgotten by many clients, and eventually end up being little more than a rounding error on a person's balance sheet," says Rick Brooks, a financial planner in Solana Beach, Calif. "The small amounts that people generally contribute to these plans almost by definition means that they are relegated to back-burner status when other financial matters come up."
With traditional DRIPs, you might hold a stock too long either through inertia, forgetfulness, or misplaced loyalty. For instance, stocks that slashed dividends during the recession (and took hits to their share price) might not build much value for a while. And since DRIPs are limited to companies that pay dividends, it's difficult to build a well-rounded portfolio using them alone, since many companies—particularly fast-growing tech stocks—reinvest their earnings rather than pay dividends.
If you're interested in DRIPs, look into ones in sectors like utilities or telecoms; a few companies, such as Piedmont Natural Gas (PNY) and TD Bank (TD), even give you a 1 to 5 percent discount on the stock's purchase price when you deposit money to buy new shares or each time the dividends are reinvested. And if you don't want to hold them in a brokerage account, look for companies that allow you to purchase the initial shares directly at no cost—especially if the initial investment is small.
You can find out if a company has a DRIP, or direct stock purchase plan, by checking the "Investor Relations" section of its website. If you're looking for general information on DRIPs and individual company programs, check out these Web resources:
This article appeared in Consumer Reports Money Adviser.