All retirement portfolios have the same goal to save up enough money to retire. The longer you contribute to this fund, the more your money is able to compound and grow. One of the easiest ways to compound your money over long periods of time is with Dividend Reinvestment Plans, also called DRIPs.
With this investment strategy, you earn dividends from owning stock shares of a company. The dividend payments are then automatically used to purchase even more shares. This snowballs over time delivering you power of compounding interest for your portfolio.
What are DRIPs?
Hundreds of publicly traded companies offer Dividend Reinvestment Programs or DRIPs. These special programs give investors an automated investment strategy. You buy shares of a company's stock, which pays a dividend payment to share profits. Instead of pocketing that money, the program automatically reinvests those dividends by purchasing more stock.
The idea behind this tactic is quite simple. Your initial investment amount grows over time by continually adding to your share count. If you start out buying 100 shares of stock in a DRIP, your quarterly payments might be enough to buy you an additional share or two. By adding 4-8 more shares each year without paying additional money, you're passively growing your investment. After 10-15 years, you could easily end up doubling the number of shares you own. This then gives you higher dividend payments each quarter, which lets you buy shares even faster.
There can be other advantages to these programs besides the long-term investment opportunity too. These programs benefit the company by making it more likely that you'll be a long-term investor and holder of their stock, which can help to boost their share price. You can benefit by potentially reducing your costs to buy. Some of these programs offer discounted shares and/or no commission benefits.
Dividend Tax Liability
One thing that you need to keep in mind with this type of investment strategy is that your dividends are taxable income. This even applies to reinvested funds from DRIP payments. Over time as your shares continue to grow and you receive larger quarterly payments, your tax liability will also grow.
This tax liability isn't a deal breaker. In fact, it's quite normal when it comes to trading equities. You simply need to be aware of it to plan accordingly. There may even be some ways to protect yourself from these tax liabilities until you retire by using tax protected accounts, but this can also be more complicated since your brokerage may not be used to buy some DRIPs.
More information can be found below relating to different places to buy DRIPs. If you have concern over an annual tax bill from this investment, look into using your brokerage retirement account for the purchases instead of the program offered directly from the company.
Why Reinvest Dividends?
When you have an investment that makes money for you every quarter, you could keep that money as income. This may actually be the plan once you reach retirement age. However, as you're growing your fund and still contributing to it, it makes more sense to reinvest dividends.
If you're taking those dividends out of your account each quarter, you'll always own the same number of shares. Your initial investment will only grow if the share price goes up. By reinvesting your dividends, you'll automatically gain more shares each quarter. Each additional quarter you will gain even more shares than before.
You end up with a snowball effect with this strategy. If you start with 100 shares, you may only get 1 new share of stock each quarter to start. Over time this number will get larger and larger though. After a few decades, you could be receiving multiple shares each quarter and have hundreds of shares in your portfolio. The idea is to reach retirement age with a lot of dividend shares, and then you can start withdrawing those payments each quarter as a fixed income.
In general, there are two main places you can buy DRIPs - from the company itself or from a third-party company such as a broker. There can be advantages and disadvantages for each. When you buy directly from the company, the biggest perk is that they will often sell you shares at a discounted rate. This can let you buy shares for as much as 10% off the public price.
The downside to buying directly from a company is that your investment stays with them. You have to use their own website portal to manage your shares for that company. If you choose to invest in DRIPs with multiple companies, you can easily end up with more accounts to manage than you really want.
Another major disadvantage to buying directly from the company happens when it's time to sell. You have to sell your DRIPs back to them, so this is also done directly with them. This process can take a couple of days, so it's next to impossible to take advantage of a spike in share price to sell this way. You may request to sell on a day when the price is great, but then the price drops two days later and you're paid out at a much lower value.
Personally, I prefer to use my normal brokerage accounts to buy and sell DRIPs. The ease to buying, selling and managing your DRIPs all in one location is more important to me than a slightly cheaper share price.
A big difference between the two options has to do with your choices. There's 600+ companies that have a dividend reinvestment plan. However, there are a lot more companies than that who pay dividends. Technically, any stock that offers dividend payments can be used for a DRIP whether the company offers that option or not. Brokerage accounts make this easy since they have options to allow for automatic reinvestment of dividends.
I'm more of an active trader with my portfolios than the average investor. I pick individual companies instead of buying ETFs and index funds. For this reason, I have to examine my portfolio every few years to ensure that my picks are still good choices. I will sometimes have to shift around my investments if I feel like an industry has changed and a company will slowly decline. For this reason, I like the ability to be able to easily sell my shares and buy into a different company. Buying DRIPs on a brokerage account gives me this option.
As with any investments, it's best to diversify. This is especially true with DRIPs. Since these dividend reinvestment plans are offered directly by a company, it's easy to limit yourself to one or a handful of DRIPs. This can be a bad thing since you'll end up with a large portion of your portfolio dedicated to a single company.
If you want to heavily use DRIPs in your portfolio, you need to pick a wide variety of companies in numerous different industry sectors. This will help to give you the most diversification possible to help ensure that your overall portfolio value increases over time.
A retirement account that only used DRIPs with a single company, perhaps a company you've worked at for decades, is very vulnerable. The entire company going bankrupt and closing can obviously devastate an investment like that. For this reason, if you only want to buy shares for a single dividend reinvestment plan then you need to make sure the rest of your portfolio is well balanced with other types of investments.