Continuing with our ‘dividend investing’ theme, I’d like to talk a bit about DRIPs. The term “DRIP” stands for “dividend re-investment plan.” In a recent column, we discussed the concept of stock dividends. In a nutshell, when a company has excess operating earnings, they can choose to reinvest those earnings in the company (by buying inventory, upgrading technology, paying down debt, making acquisitions, etc.), or they can return that cash to the shareholders in the form of dividends.
In their purest form, dividends are paid to shareholders by check, or the equivalent amount of cash is credited to their brokerage accounts.
Companies that offer DRIP plans, however, do something a little different: Instead of sending DRIP participants a check, they will simply credit them with as many shares, or fractions of shares, as their regularly scheduled dividend will buy. DRIP participants generally don’t purchase shares from a broker. Instead, they buy shares directly from the company’s department of investor relations, or from a transfer agent.
You can usually start a DRIP plan with a company for a very small amount of money – sometimes as little as a single share. DRIPs can be good for smaller investors, because their dividends may not otherwise be big enough to do anything with: Not enough money to buy more shares with, efficiently, and not enough to make it worthwhile to keep around in a money market fund.
For this reason, DRIP programs can be good for those with smaller accounts, who still want to hold individual securities. They allow a way for very small investors to dollar cost average small amounts of money into company shares, often without having to pay onerous brokerage commissions, which can be very inefficient for very small transactions.
They can also be very good gifts – for example, a grandparent can “gift” a very young child a few shares in, say, Campbell’s Soup. Campbell’s will continue to issue dividends, of course, but the cash will be credited to the child in the form of additional shares or fractions of shares. The parent and grandparent can teach the child the basics of investing through ownership of a company that the child can understand.
If you want to scale up, it is quite possible to build a portfolio consisting of dozens, or even hundreds of companies that sponsor DRIP programs – building up a sizeable investment portfolio, but with generally lower commissions, fees and expenses you would associate with mutual funds and brokerage accounts.
This is a laborious process, though, in practice – so it’s best suited for true DRIP aficionados.
You also have the advantage of a lot more tax planning flexibility than you would get in a single mutual fund. For example, you can manage your exposure to capital gains taxes by selling money losers along with winners, to the extent practicable. Capital losses cancel out gains, thus lowering your capital gains tax bill – a practice known as “tax loss harvesting.”
Disadvantages of DRIPs
Any dividends you receive are taxable – normally as qualified dividend income, if the companies are qualified U.S. companies. This is true, even if you don’t personally receive a check. The company will issue you a Form 1099-DIV, and you must declare this as qualified dividend income on your taxes.
If, instead, you elected a company that didn’t generate dividends at all, but instead reinvested all of its earnings back into the company, you would be able to defer those taxes until such time as the company did issue a dividend (Meanwhile, Uncle Sam still gets a cut if you sell shares at a profit, in the form of a capital gains tax, except in retirement accounts).
As a practical matter, DRIPs don’t function well in IRAs, because you need a formal custodian to hold assets within IRAs. There are ways to do it by opening up a self-directed IRA account with a third-party administrator, but that probably only makes sense as part of a larger self-directed IRA strategy. More on those in a future column!
Those on limited budgets who use DRIPS are also taking on quite a bit of individual security risk. Companies can and do go out of business from time to time, and shareholders can potentially by wiped out. If you don’t want to bet the whole caboodle on one company, there are also mutual funds that accept relatively low minimums, if you commit to a monthly amount in a retirement plan. This will instantly diversify your holdings among dozens, hundreds and even thousands of companies, in some cases – and they will also reinvest your dividends for you in the form of fund shares.
This could be a better solution, depending on your budget, risk tolerance, and overall situation. If you want to know more about either DRIP plans, or options for low-minimum mutual fund investing, please give our office a call. We would love to work with you.