Dividend reinvestment plans (DRIP) are often used by investors to automatically compound their investment returns. Before you think it’s obvious, ask yourself if reinvested dividends are taxable?. Your after-tax returns can be significantly affected by the answer. Reinvesting each dividend can reduce your liquidity and increase concentration risks. Know what to lean in (or out).
Understanding dividend reinvestment plans
When you receive a payout, you have two choices: either take it in cash or reinvest. Dividends are usually paid directly to investors if not participating in active DRIPs.
DRIPs are a way to reinvest dividends in the purchase of additional shares. Reinvestment takes place on the date of dividend payment, be it monthly, quarterly or semi-annually. The market value of the investment determines how many shares are acquired.
Taxation of dividends reinvested
Dividends are not all treated the same. To maximize your DRIPs, you need to understand the difference between ordinary and qualified dividends.
U.S. companies or qualified foreign entities pay qualified dividends. These dividends must be held over a certain period of time to qualify for favorable treatment. You may be eligible for long-term gains tax rates of 0%, 15% or 20% depending on your income bracket. Ordinary dividends will be taxed according to your normal income rate.
Knowing whether you have ordinary or qualified dividends can help you to forecast your tax situation since reinvested dividends are subject to taxation in brokerage accounts
What happens if you reinvest your dividends?
Imagine you own 100 shares in a company which pays a dividend of $1.00 per share quarterly. Without reinvesting your dividends, you would receive $100 each quarter. Enrolling in DRIPs allows you to automatically buy more shares with that $100.
If the stock is trading at $50 per share then your $100 dividend will buy you additional shares. You now own 102 shares. If the dividend payment is not exactly in line with the price of the stock, you can still purchase fractional shares as DRIPs often accommodate fractional shares.
When to reinvest dividends and when to take cash instead
Reinvesting dividends is a great way to compound wealth. This is especially true in tax-advantaged account types such as IRAs or 401(k), where dividends reinvested are not taxed. Reinvesting dividends can be a powerful tool for compounding wealth. If your portfolio is well-diversified with broad-based ETFs or mutual funds, reinvesting can help maintain steady growth.
If you have a concentrated position in stocks, taking the dividends as cash could be the best option. Reinvesting would increase your exposure to risk specific to the company. Dividends paid in cash give you the option to diversify your portfolio by reinvesting into other investments.
Portfolio imbalance: a hidden risk with DRIPs
DRIPs are a great way to simplify your investing. However, they can also expose you to more stocks. This can cause portfolio imbalance, especially if you automatically reinvest a large portion of your portfolio into one stock. DRIPs can overload your portfolio if they are concentrated in a single sector or stock. Reallocate dividends into other investments rather than reinvesting them in the same security.
Reinvesting dividends automatically might seem the best move, but does it serve your larger financial picture? You can take control of your finances by creating a tailored dividend strategy. This will help your money to work towards your goals, rather than blindly following defaults.
Conclusion
Dividend Reinvestment Plans (DRIPs) provide investors with the chance to slowly build wealth by putting dividends to work in a way that is automatic. Instead of cash payouts and reinvesting the dividends, they help create a greater share of the market, and compounding dividends over time, without the stress of trading. No matter if you’re an experienced investor looking to build your portfolio over time or an aspiring investor looking for a more disciplined approach in investing, DRIPs offer an accessible cost-effective strategy to boost your portfolio.
We at Parr & Ibarra CPA in Keller, Texas believe in helping investors develop financial strategies that match their long-term objectives. If you’re looking to learn the ways DRIPs as well as other investments can aid in your financial goals, our team is ready to help you through every step of the process.
