Dividend Reinvestment Plan (DRIP) Definition
In this video, you’ll learn about dividend reinvestment plans (DRIPs). A dividend reinvestment plan is a program that allows investors to reinvest their cash dividends into additional shares or fractional shares of the underlying stock on the dividend payment date. Most DRIPs allow investors to buy shares commission-free or for a nominal fee, and at a significant discount to the current share price. DRIPs offer shareholders a way to accumulate more shares without having to pay a commission while dividend-paying companies also benefit by receiving more capital to use. Watch this video to get more information on DRIPs.
Reviewed by Julius MansaFact checked by Vikki VelasquezReviewed by Julius MansaFact checked by Vikki Velasquez
Mutual funds have made dividend reinvestment easy but reinvesting dividends earned from exchange-traded funds (ETFs) can be slightly more complicated. Dividend reinvestment can be done manually, by purchasing additional shares with the cash received from dividend payments, or automatically through dividend reinvestment plans.
Automatic dividend reinvestment plans (DRIPs) directly from the fund sponsor aren’t yet available on all ETFs. However, most brokerages will allow you to set up a DRIP for any ETF that pays dividends. Today, one way or another, this option should be available on virtually all ETFs. This can be a smart idea because there’s often a longer settlement time required by ETFs. Their market-based trading can make manual dividend reinvestment inefficient.
Key Takeaways
- Dividend reinvesting can be done via dividend reinvestment plans (DRIPs) or manually.
- The ability to automatically reinvest dividends is readily available today.
- Brokerages handle automatic dividend reinvestments differently.
- A disadvantage to automatic dividend refinements for ETFs is that investors lose the ability to time the market.
- Manual dividend reinvestment is less convenient but it provides more control.
Dividend Reinvestment Plans (DRIPs)
An automatic DRIP is a program-offered fund or brokerage firm that allows investors to have their dividends automatically used to purchase additional shares of the issuing security. This practice is widely available.
DRIPs offer greater convenience and a handy way to grow your investments effortlessly . In the past there were more issues for ETF shareholders because of the variability in programs. Some brokerage firms offered automatic dividend reinvestment, but they only allowed the purchase of full shares. Any amount that’s left over was deposited as cash into the investor’s brokerage account. Other firms pooled dividends and only reinvest dividends monthly or quarterly. However, today, the most common scenario is that the dividends will be completely reinvested when issued, because of the prevalence of fractional shares. Even if your dividends can only purchase 0.05 shares, they will be reinvested, and 0.05 will be added to the quantity of shares you own.
Some reinvest dividends at market opening on the payable date. Others wait until the cash is deposited, which is typically later in the day. ETFs trade like stocks and their market prices can fluctuate throughout the day so a reinvestment executed at 7:00 a.m. may buy a different number of shares than a trade that’s executed at 10:00 a.m.
This is one of the drawbacks of automatic ETF dividend reinvestment. The investor loses control of the trade and can’t “time” the market to their advantage. However, this is not a big concern for many ETF investors as they tend to favor a long-term, buy and hold strategy.
Manual Reinvestment
You can still reinvest dividends manually if your brokerage firm doesn’t provide a DRIP option or if the ETFs in which you are invested don’t allow for automatic reinvestment. Manual reinvestment means taking the cash earned from a dividend payment and executing an additional trade to buy more shares of the ETF. You may incur a commission charge for these trades, just like you would with any other trades, depending on where you hold your investment account. Commission-free trading is now commonplace in the online brokerage industry, but some providers may still charge a commission. Of course, traditional, full-service brokers will charge a commission.
Major online brokerages offer commission-free dividend reinvestments.
Manual dividend reinvestment is less convenient than a DRIP but it provides the investor with greater control. You can elect to wait if you feel that the share price may drop rather than simply pay the market price for new shares on the payment date. It also offers the option of choosing to invest the dividends in another security different than the ETF that issued them.
In January 2024, the U.S. Securities and Exchange Commission made a decision that expanded investor choices in the ETF space. The commission approved 11 spot market Bitcoin ETFs.
Be Prepared for Delays
Be aware of the effect of settlement delays on the buying power of your dividends if you elect to manually reinvest your ETF dividends. Unlike mutual funds, ETFs rely on brokerages to keep track of their shareholders so dividend payments typically take slightly longer to settle. Rather than the one-day settlement period of most mutual funds, ETF payments can take up to one business day plus the trading day to settle.
The additional wait time can mean that you end up paying more per share if your ETF is doing well.
Do ETFs Pay Dividends?
If the shares or other holdings in an ETF’s portfolio pay dividends then they’re also payable to shareholders of the ETF. A few ETFs will pay dividends as soon as they’re received from each stock held in the fund but the majority collect those dividends and distribute them every quarter.
Why Should I Reinvest ETF Dividends?
Unless you need the cash flows generated from dividends for income, reinvesting those proceeds to buy more ETF shares can compound returns over time and lead to even greater dividend income down the road.
Are ETF Dividend Reinvestments Taxed?
Yes. The Internal Revenue Service (IRS) treats dividends that are reinvested the same as if they were received as cash. They must be reported on your tax returns.
Why Are DRIPs Preferred to Manual Reinvestment with ETFs?
A DRIP helps to eliminate problems with timing the reinvestment of ETF dividends. Unlike shares of stock that have a transfer agent and custodian tracking all shareholders of record for dividend purposes, ETFs rely on investors’ brokerages to track this. There can also be delays in when ETF dividends are distributed and when they hit an investor’s account, making manual timing more difficult.
The Bottom Line
Reinvesting your ETF dividends is one of the easiest ways to grow your portfolio but the structure and trading practices of ETFs mean that reinvesting may not be as simple as reinvesting mutual fund dividends. Consult your brokerage firm to see which of your ETFs are eligible for DRIPs and how the brokerage handles these trades.
Keep track of settlement periods to ensure that you don’t poorly time your reinvestment if you must manually reinvest. Setting a market order for the moment when your dividend is deposited may not get you the best price per share so use manual reinvestment to your advantage by actively managing your trades.
Read the original article on Investopedia.