What is a Dividend Reinvestment Plan?
A dividend reinvestment plan, or DRIP, is a program offered by many companies and most mutual funds to reinvest dividends for free in additional shares.
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Benefit to Company
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The benefit to the companies (and mutual funds) is that they do not have to incur the expense of mailing out quarterly dividend checks to investors. The popularity of DRIPs also helps foster stronger relationships with investors.
Benefits to Investors
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Investors benefit by accumulating additional shares with the dividend money they would otherwise be spending, as well as through compounding---earning income on income by reinvesting it.
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Disadvantages
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The disadvantage of a DRIP is the accounting at tax time after an investor sells. To calculate a capital gain, an investor must determine the cost basis, which includes multiple, often fractional, share purchases over the years through dividend reinvestment. Some investors neglect to factor in the cost of shares purchased through DRIP and use only the amount of the original and subsequent cash purchases, inadvertently overstating the amount of capital gain and subjecting themselves to a higher tax liability.
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References
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