Not everyone who purchases investments wants or needs the income today. In many they’re trying to grow a nest egg to fund a future goal, such as retirement. These investors may want to see more growth in their portfolios and may not be attracted to investments that pay investment income.
Many investments have both a growth and income component. Fortunately most of these same companies offer the dividend reinvestment program – often referred to as a “DRIP.” Growth is often achieved through price appreciation of the investment and also reinvesting the income.
An investor purchased 400 shares of the common shares of ABC Corporation currently trading at $30. The current quarterly dividend is set at .25 per share. Based on these values, when the dividend is payable, the investor would receive (400 x .25 / $30) approximately 3 shares of ABC and $10 cash. After the dividend the investor would own 403 shares.
Although the investor above may have requested that their dividends be reinvested, the dividend income will still be considered income for taxable accounts in the year the dividend was declared. Investors will receive the applicable taxation slips and should ensure they have sufficient cash on hand at the end of the year to pay any tax liability. DRIPs in an RRSP account are ideal as any income is deferred and is not taxed immediately.
The DRIP program has investors acquiring shares at different prices with each dividend being reinvested. For taxable accounts it is important to keep track of the costs at which the new units were reinvested. The cost of the original purchase plus the total value of the shares reinvested on the date of the DRIP equals the adjusted cost base.
There are no commission charges for the DRIP program. Certain investments automatically reinvest distributions without being set up under the DRIP program. Many investments do not have a DRIP program. Investors can provide their investment advisor a copy of their statement and request which positions are eligible to be set up as a DRIP.
Unlike mutual funds, it is not possible to have fractional shares of common shares. The illustration above highlights that the fractional portion (less than the amount to purchase a whole share) is paid as cash into the investment account. Stock splits are generally a good thing for individuals that have the DRIP program. Share prices are generally reduced resulting in a greater portion of the dividend being reinvested.
Years ago investors were warned that they may have difficulties selling shares of companies if they had an odd lot. A lot is generally considered 100 shares. One can easily see how the DRIP program would result in an odd lot situation. Today this is less of a concern for any position that has a moderate volume of shares traded daily. With reorganization, spin-offs and computerized trade execution many investors have odd lot holdings.
Investors should take care to monitor their position sizes. Investors may find over time that certain positions that are set up as a DRIP may become overweight within their overall portfolio. Investors who have charitable intentions may want to consider donating shares or sell a portion of their holdings as a means to rebalance the portfolio.
A DRIP can easily be cancelled. An investor may want to cancel a DRIP when they begin to require income from their investments.
Growth oriented investors may find the DRIP a low maintenance way of dollar cost averaging while reducing the costs of investing and employing cash that may otherwise be earning a low return in an account. The DRIP allows compounding of investment returns which can enhance total returns.