When shareholders are paid a dividend from a company or investment fund’s profits, they’re often given a choice: Take the money and do something else with it, or use the cash to buy more shares. If they choose the latter, one way to do it is through a dividend reinvestment plan, or a DRIP, which can automate this process.

What is a dividend reinvestment plan (DRIP)?

Dividend reinvestment plans, offered by many corporations and brokerages, as well as some exchange-traded funds (ETFs) and mutual funds, allow investors to use their dividends to buy more shares (or fractional shares, if offered) of the company or fund without having to actively initiate a transaction. The goal is to simplify the process of building wealth through compound returns.

How dividend reinvestment plans work

Usually, dividends are paid by check or electronic deposit, which are sent automatically to investors, either quarterly by a company or monthly by a fund. When investors opt into a DRIP, however, these dividends are held for reinvestment instead.

When shares are bought through a company DRIP, the stock often comes directly from the corporation’s own reserve, rather than through a share purchase on a public stock exchange. Companies and funds sometimes offer discounts on shares purchased through a DRIP, and DRIP transactions usually are free of commissions or offered for a lower fee.

Some DRIPs have reinvestment minimum requirements. For example, cash from dividends may be held in reserve until investors have accumulated a certain dollar amount (say, $10). Once the minimum is reached, the money is reinvested into new shares.

Many DRIPs also allow for the purchase of fractional shares. This means that investors’ dividends can be reinvested to purchase a fraction of a share of that stock, rather than waiting until they have enough dividends built up to purchase an entire share.

Fractional shares can help put investors’ money to work sooner, and make it easier to buy into stocks that have a higher price tag. For example, buying a full share of Apple stock would cost about $150 as of mid-September 2021. The stock paid an annual dividend of just $2.615 per share in 2020, meaning someone who owned just a few shares would be hard-pressed to buy an entire share right away using dividends alone.

With fractional shares, investors can purchase a small piece of a share with the dividends they have available. Over time, these small fractions can build up to full shares.

Pros and cons of DRIP investing

There are a few reasons investors might be interested in dividend reinvestment plans, but there are some drawbacks.

Advantages of dividend reinvestment plans

• Money goes to work sooner

  . Time and compounding are two of the most significant factors when it comes to growing investment wealth. Dividend reinvestment addresses both, especially if fractional shares are offered. Investors’ dividends are used to purchase additional shares without any unnecessary lag, helping to build their investment portfolio. These new shares will provide additional dividend income in the future as well as the potential for greater share appreciation.  
  

• DRIPs automate the reinvestment process

  . Without a dividend reinvestment plan, investors are responsible for putting their dividends to work on their own. This means manually choosing an investment route and actually processing the transaction. There is room for delay and human error here, which can cost investors money in the end.
  

• New shares may be purchased at a discounted price

  . Some companies may offer reinvestment shares at a discounted price, which may come from the company’s private reserve. This can save investors money and allow them to purchase even more shares.

Disadvantages of dividend reinvestment plans

• Shares may not be offered at the preferred price

  . With automatic dividend reinvestment, investors have no say over when new shares are purchased or at what price. In some cases, this may mean paying more for a stock than they’d like.
  

• Investors may need to use that dividend income

  . Dividends are a beneficial form of passive income, which can go toward many investment efforts or even help fund retirement. If opting into a DRIP, however, investors aren’t able to access those extra funds without unenrolling.
  

• It can contribute to an unbalanced portfolio

  . Over time, stock growth and reinvested dividends can shift an investment portfolio’s allocations, which could impact investment goals.

How to enroll in a dividend reinvestment plan

To enroll in a dividend reinvestment plan, investors will need to see which options are available to them.

Though DRIPs may refer to any plan that automatically reinvests dividends, they are most often offered by publicly traded corporations and some funds. Shareholders can enroll in one of these programs to automate their dividend reinvestment by filling out a DRIP application with the company or fund, assuming that they meet all other requirements. Some DRIPs allow enrollment with as little as one share, while others may require more.

If enrolling in a DRIP through a brokerage, it can be as simple as opting in for automatic reinvestment through the firm’s website. Depending on the brokerage and even the specific shares owned, dividends may be held until full shares can be purchased or until investors build up a minimum dollar amount.

Are DRIPs taxable?

A dividend reinvestment plan isn’t an investment in and of itself. Rather, it is simply a mechanism that automates the process of reinvesting the dividends investors have already earned, in order to purchase additional shares of stock. For this reason, there isn’t a dividend reinvestment tax, per se.

That said, the dividends processed through a DRIP may be taxed in a few different ways, depending on:

• The company itself
• How long the investor has held the stock
• The investor’s taxable income
  

Dividends may be qualified or unqualified, also known as ordinary. Ordinary dividends are taxed as ordinary income at investors’ normal tax rate.

Qualified dividends are offered by eligible US-based and foreign corporations to investors who meet holding period requirements. These dividends are taxed at either 0%, 15%, or 20%, depending on the investor’s overall taxable income for that year.

The bottom line

With a dividend reinvestment plan, or DRIP, investors may automatically put their dividends to work by purchasing new shares of stock. This hands-off process may compound investors’ wealth-building efforts—by regularly buying additional shares of stock—and help amplify future earnings and passive income.

DRIPs are offered by many publicly-traded corporations, funds, and brokerage platforms, and may allow investors to buy either full or fractional shares of stock. Opting into a dividend reinvestment plan depends on each investors’ financial strategy, the stocks owned, and their plans for passive income.