Pros & Cons of Dividend Reinvestment Plans
One important feature of the stock market is the fact that some stocks pay investors dividends. A dividend is a pre-set cash payment that some companies pay per share. Investors receive dividends whether or not the stock performs well, so that the money helps to increase the value of owning a high-performing stock or cushions the losses that a poor-performing stock incurs.
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Reinvesting Defined
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Dividend reinvestment plans, or DRIPs, are programs that companies offering stock dividends provide for their shareholders. With a DRIP, investors can choose to have their dividends reinvested directly in the company in the form of additional shares of stock. Over time, the number of shares an investor has will grow. Investors can also choose to make additional investments in the company by purchasing more shares directly instead of going through a broker.
Benefits
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DRIPs allow a shareholder to benefit from stock ownership in two ways, as both the number of shares and the value of each share have the potential for growth. Even when the stock price holds steady or declines, the extra shares that come from a DRIP can offset the losses or provide profits when it is time to sell. DRIPs also allow investors to avoid the fees that brokers charge to buy additional shares in a company.
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Drawbacks
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DRIPs are not an ideal program for every investor. In particular, more sophisticated investors may find that the automatic, annual reinvestment is too restrictive. Investors who want to buy and sell shares at-will are better off making transactions through a low-cost broker. DRIPs also force investors to put the earnings from dividends back into the same company regardless of performance.
Alternatives
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DRIPs are only one way of receiving dividend earnings from stocks. Investors can elect to receive a cash payment instead. Investors with a large number of shares may be able to live off dividends without selling shares except to make major purchases. The cash from dividends can also go back into the market if the investor chooses to purchase shares of another company, giving cash dividends more flexibility.
Tax Consequences
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DRIPs can have an effect on an investor's income taxes. Receiving dividends in the form of cash falls under the heading of investment income, and investors have to claim this money as taxable income each year. However, with a DRIP, investors only have to pay tax on the earnings when they sell their shares.
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- Photo Credit stock chart with a pencil mark image by Dmitriy Lesnyak from Fotolia.com
