What is a dividend reinvestment plan?

If you’ve ever had to place a bucket under a leaky faucet, you’re well aware that those individual droplets can fill your pail pretty quickly. Dividends can have a similar effect on your portfolio.

Dividends — money some companies pay to their stockholders as a way to share profits — don’t always provide a ton of income on their own, but what you get is hardly chump change. When you own dozens, hundreds or even thousands of shares, those small amounts can add up — especially if you’re reinvesting the money.

Here’s how a dividend reinvestment plan, better known as a DRIP, works.

What is a dividend reinvestment plan, or DRIP investing?

The principle is simple: When you invest in any one of the many companies that offer a DRIP program, the dividends you receive are automatically directed toward the purchase of more shares in the company. Each new drop in the bucket may seem trivial on its own, but, as the years roll by, the benefits of compounding and dollar-cost averaging have the potential to turn those tiny drips into an overflowing portfolio of equities. Of course, no investment is guaranteed to rise, and investments can and do lose money.

How does DRIP investing work?

When you use your dividends to buy more shares in a company, your investment has the potential to grow faster because of the power of compounding. Let’s say you own 100 shares in a company that pays a dividend of $0.50 per share, each quarter. Your first dividend payment will be $50. If the company’s shares are trading for $25 per share, you’ll automatically gain two more shares with a DRIP, bringing your total to 102 shares. Your next dividend payment will be based on this new share total, thereby compounding the growth of your investment. If a company makes changes to the dividend payout however — for example, if it reduces or eliminates the dividend as a result of a material decline in earnings — this could impact your DRIP.

Total return vs. simple return

There are a few ways to look at your investment returns.

Simple price return: This calculation looks at how much your investment has risen (or fallen) between two periods, excluding dividends.

Total return: This approach reflects the actual rate of return of your investment over time. This calculation takes into account any dividends, interest, distributions and capital gains you collect.

Taxes and DRIP investing in Canada

If your DRIP is held in a non-registered account, the dividends you receive still count as income even if they are reinvested, meaning you will have to pay tax on them in the year they are received. Of course, if you hold your DRIP stock in a Registered Retirement Savings Plan (RRSP), you will only pay tax once this money is withdrawn. If it’s held in a Tax-Free Savings Account (TFSA), you won’t pay any tax. However, if you’re holding U.S stocks in your TFSA, the IRS will typically apply a withholding tax of 15% on any dividend income you earn.

It’s important to note that, as with any stock, there will also likely be capital gains considerations when the investment is eventually sold.

DRIP vs. DCA

Dollar-cost averaging (DCA) is a financial strategy that involves making regular investments in a stock, ETF or mutual fund throughout the year, rather than trying to time the market with a lump sum. Some days the price is up, some days it’s down, but either way, you don’t have to worry about identifying the perfect time to buy (which is nearly impossible for most people).

A DRIP program accomplishes something similar — you are reinvesting your dividends (and purchasing more shares) at regular points throughout the year, no matter the price.

Advantages of DRIP investing

What’s in it for investors?

• Share purchases are automatic and commission-free.
• The power of compounding can accelerate your gains.
• You could benefit from dollar-cost averaging.
• If your DRIP is inside a registered account, some taxes may be deferred or avoided, depending on the account.

What’s in it for the companies and key stakeholders?

• Usually, when an investor buys shares in a company, they’re buying from another investor, not the company directly. When a shareholder reinvests their dividends though, the additional shares are sold by the business. This gives the company more capital to grow the business, which can help raise its share price.
• Shareholders who take advantage of DRIP programs are generally more inclined to hang onto their shares when the stock value decreases.

Disadvantages of DRIP investing

• Reinvesting your dividends may not be ideal if you are looking to generate income from your portfolio.
• Dividends outside of a registered account will be taxed. If your dividends are reinvested, this could mean you pay that tax out of pocket.
• Continually reinvesting your dividends can lead to overexposure to a particular company or sector. This, in turn, may require you to rebalance your portfolio in the future to help ensure you hold an appropriate mix of assets.
• Companies facing financial difficulties may reduce or stop paying dividends altogether.

Key considerations before you invest through a DRIP

A DRIP can be a means to grow your portfolio while saving money on commission. The automatic nature of the process can also help prevent personal procrastination from getting in the way of your financial goals. But keep in mind, when you opt to reinvest your dividends, you are giving up access to a stream of investment income.

How to invest with a DRIP

Many online brokerages, including those offered by TD, allow you to set up a DRIP that will apply to all eligible stocks in your account or individual securities of your choosing. To set up a DRIP with your TD Direct Investing account, contact an Investment Representative at 1-800-465-5463 or (416) 982-7686.