Q. I never hear about DRIPs anymore. Are they still a good idea? I used them when I was young and now my son wants to start investing.
A. A DRIP, which stands for dividend reinvestment plan, allows investors to buy shares of a company and cash dividends are automatically reinvested by purchasing additional shares or fractional shares on the dividend payment date.
A DRIP may be a very effective way for investors who do not need or want to take their dividends in cash to reinvest into the stock to purchase more shares, said Michael Cocco, a certified financial planner with AXA Advisors in Nutley.
“Purchasing more shares would then increase the potential dividend as their quantity of shares grows,” Cocco said. “This is seeing `compound interest’ at work in its purest form, as the dollar of the dividend would increase each period as the number of shares increases, which then will allow the investor to buy more shares at the next dividend date, and so on.”
Cocco said a key advantage to using a DRIP plan is that most DRIP plans allow investors to buy more shares automatically, free of commissions or fees, to help them accumulate their wealth. Some, but not many, stocks offer a slight discount on the price per share if using their dividend reinvestment program direct with the company.
In the past, DRIP plans were a very popular way to invest. They still have some merits today, Cocco said, but there are some potential drawbacks.
First, when you are engaged in a DRIP plan, you are buying shares in just one company.
“This lack of diversification could have issues if that particular company fell on hard times or significantly lagged the performance of the overall market,” Cocco said. “We have all heard the advice to not have `all your eggs in one basket,’ and with a DRIP, you could be over-concentrated in one company.”
He said a potential strategy to avoid this would be to set up DRIP plans with multiple companies to create diversification.
But event that strategy has a drawback, Cocco said. Because as each DRIP is set up, a separate 1099 tax form would be sent out for each account, which could make tax planning more difficult because there would be multiple accounts and tax forms to keep track of.
“What many investors do to address this is to hold these stocks in one consolidated brokerage account so there is one account and one tax form,” he said. “This setup will still allow the diversification that comes from holding the stock of multiple companies.”
Overall, Cocco said, DRIP plans can sometimes sound like a “no-lose” situation, but an investor needs to remember that he or she is still investing in stocks, which carry market risk.
That’s why it’s important to work with a financial advisor to gauge one’s personal risk tolerance and time horizon, to make investment decisions that would be in line with the investor’s goals and objectives, he said.
“It is important to note that even if you choose to reinvest the dividend instead of taking the cash, those dividends are still reportable as income for tax purposes, and I urge clients to speak with their tax advisor for more details on the taxability of any investment and the potential earnings,” Cocco said.
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