Dividend Reinvestment Plan (DRIP)

Discover all you need to know about dividend reinvestment plans (DRIPs), encompassing their various types, advantages, and drawbacks.
EXPLORE FUNDS
3 mins read
30 March 2024

A dividend reinvestment plan (DRIP) is a type of scheme that lets shareholders automatically reinvest their dividends into additional shares of the same company. This is in lieu of receiving dividend pay-outs in cash.

DRIPs can be an affordable way of investing in the stock market as you can buy more company shares out of your profits, without paying any commission or brokerage. Like this, you can own more shares and compound returns over time.

How do dividend reinvestment plans work?

Dividend reinvestment plans work by using the cash dividend from the investment portfolio to buy more of the underlying investment. For instance, let us say Priya holds 10 shares of company ABC. The company announces a dividend of Rs. 1.5 per share for the financial year. The NAV at the end of the year is Rs. 15. Priya’s total investment value rises to Rs. 150 (10 x 15).

In a dividend payout plan, Priya would receive Rs. 15 (10 x 1.5) as cash dividend and her investment value would reduce to Rs. 135 i.e., (10 x 13.5). In a dividend reinvestment plan, Priya would not receive any cash dividend, but instead, she would get additional shares of the company. The number of shares she would get would depend on the market price of the shares on the date of dividend payment. Assuming the market price is Rs. 13.5, Priya would get 1.11 shares i.e., (15 / 13.5) as dividend reinvestment. Her total number of shares would increase to 11.11 and her investment value would remain at Rs. 150 i.e., (11.11 x 13.5).

Features of DRIPs

  • They help investors to increase their ownership in the company and benefit from the power of compounding.
  • They reduce the transaction costs and fees associated with buying shares in the open market.
  • They enable investors to take advantage of the fluctuations in the market price and buy more shares when the price is low and fewer shares when the price is high.
  • They provide a steady and regular source of income for investors who do not need immediate cash from their investments.
  • They offer tax benefits for investors as they defer the payment of capital gains tax until the shares are sold.

Types of dividend reinvestment plans

  • Company-run DRIPs: These are run and operated by the company in which an investor owns shares. The companies offer these plans directly to their shareholders. They may offer a discount on the purchase of additional shares through DRIPs, as well.
  • Brokerage firm DRIPs: These are run by stock broking firms on behalf of their clients. The brokers buy shares in the open market and may or may not charge commission for such purchases.
  • Third-Party DRIPs: These are run by a third party which operates these plans. Their main benefit is that they let investors consolidate their shares in one place, making it easier to manage their portfolios.

Advantages of a dividend reinvestment plan

Some of the advantages of a dividend reinvestment plan are:

  • It helps investors to build a long-term wealth by reinvesting their dividends and increasing their shareholding in the company.
  • It allows investors to benefit from the growth potential of the company and its future dividends.
  • It enables investors to diversify their portfolio and reduce their risk by investing in different companies and sectors.
  • It gives investors the flexibility to choose the amount and frequency of dividend reinvestment according to their financial goals and needs.
  • It simplifies the record-keeping and tracking of the investment performance as the investors receive a consolidated statement of their holdings and transactions.

Disadvantages of a dividend reinvestment plan

  • It may not be suitable for investors who need regular cash flow from their investments or who prefer to invest their dividends elsewhere.
  • It may expose investors to higher market risk as they buy more shares when the price is high and fewer shares when the price is low.
  • It may incur additional taxes and fees for investors as they must pay tax on the dividends received and the capital gains realised when they sell their shares.
  • It may limit the investors’ control and choice over their investments as they must follow the rules and regulations of the DRIP provider.
  • It may complicate the calculation and reporting of the cost basis and the taxable income of the investors as they need to account for the fractional shares and the varying purchase prices.

Conclusion

DRIPs can be a cost-efficient way of investing in the stock market as they allow investors to purchase additional shares of the company without paying a commission or brokerage fees. However, DRIPs also have some drawbacks and limitations that investors should be aware of before opting for one.

Frequently asked questions

Is reinvesting dividends a good idea?

Reinvesting dividends can be a good idea for long-term investors who want to benefit from compounding and lower cost basis.

Do I have to pay taxes on dividends if I reinvest them?

Yes, you have to pay taxes on dividends even if you reinvest them, as per the Finance Act, 2020.

How do I reinvest dividends to avoid taxes?

You cannot avoid taxes on dividends by reinvesting them, but you can claim deduction of interest expense incurred against the dividend income.