A DRIP, or dividend reinvestment plan, can be an extremely valuable tool for long-term investors looking to maximize the compound returns of their dividend stocks. With a DRIP, all of your dividends are automatically invested, commission-free, into additional shares of the same stock -- even if your dividend payment isn't enough to buy a full share. Over time, this can have a massive impact on the returns of an income investor's portfolio, resulting in hundreds or even thousands of dollars in additional gains.

What is a DRIP?

DRIP stands for dividend reinvestment plan, and the concept is simple. When stocks you own pay you a dividend, a DRIP automatically reinvests those dividends into additional shares of the same stock, instead of just adding cash to your brokerage account.

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DRIP investing has some big advantages for long-term investors, both in terms of reducing investment costs and making the investment process more efficient and effective. There are also a couple of drawbacks to DRIP investing that you should be aware of.

4 advantages to DRIP investing

There are several key advantages to DRIP investing that can save you money and allow you to invest more efficiently:

  1. Stock purchases made through a DRIP are commission-free. If you receive a $100 dividend payment from one of your stocks, and your brokerage charges a trading commission -- for this example $6.99 -- you would effectively only have about $93 to put to work if you were to simply buy shares yourself. On the other hand, if you received the same $100 dividend payment from a stock you have enrolled in a DRIP, you don't have to spend the additional $6.99 and you gain $100 worth of the stock. In essence, you have $6.99 more to put to work. This may not sound like a big difference, but it can really add up to serious savings over time. If you own a stock for 30 years and it makes quarterly dividend payments, this translates to nearly $840 in savings in commissions alone, not including the additional effect of that $840 being invested.
  2. DRIP investing lets you buy fractional shares of a stock. This allows you to put your entire dividend payment to work regardless of the share price. As an example, let's say that you own 100 shares of Apple, which is trading for approximately $185 per share as of this writing. At the company's current dividend rate, you would receive a $73 dividend payment each quarter, which wouldn't allow you to buy even one additional share of Apple. However, with DRIP investing, your $73 dividend could be used to buy roughly 0.4 shares of Apple, allowing you to put your entire dividend to work right away rather than waiting until you accumulate enough to purchase a whole share. This makes investing far more efficient, particularly in terms of long-term compounding.
  3. Using a DRIP lets you take advantage of an investing concept: Dollar-cost averaging. If you aren't familiar, dollar-cost averaging involves investing identical amounts of money into a stock at regular intervals, which is exactly what DRIP investing does. The idea is that when a stock's price is low, your investment will buy more shares. Conversely, when the price is high, you'll buy fewer shares. Over time, this ensures that you'll most likely invest at a better average price than you would have if you had simply bought the same number of shares in one purchase.
  4. DRIP investing automates the compounding process. In other words, you won't have to check which stocks paid you dividends recently and how many new shares you can afford to buy. Just enroll in a DRIP and your brokerage will do the work for you.

Disadvantages of automatic reinvestment

Now, this isn't to say that there aren't any negative aspects of DRIP investing to consider. Here are two potential downsides to DRIP investing that you should be aware of before enrolling in a DRIP:

  • Freedom of choice. DRIP investing takes away your freedom of choice in how your dividends are reinvested. Let's say that my Apple stock just paid me a quarterly dividend, but I feel Apple is too overvalued right now (I don't, but let's just say). Meanwhile, I think some other stocks in my portfolio, such as Caterpillar, are attractively priced.

    If I wasn't enrolled in a DRIP, I could use my Apple dividends to buy more Caterpillar stock, since I think it's the better deal right now. Of course, you can always choose to temporarily disenroll your "expensive" stocks from the DRIP, but this somewhat defeats the purpose of automating your dividend reinvestment in the first place.

  • Taxes. The other consideration only applies to DRIP investing in a standard (non-retirement) brokerage account, not to DRIP investing in an IRA or other tax-advantaged accounts. It's important to realize that when you receive a dividend payment from a stock you own, the amount of the dividend is taxable income. Many dividends are considered "qualified dividends" and are taxed more favorably than ordinary income, but they are still taxable.

    Here's the point. Even if your dividends were used to reinvest in the same stock automatically, the amount of the dividend is still taxable. As a simplified example, let's say that you have a taxable brokerage account with 100 shares of Apple, which pays you a $73 quarterly dividend, as we discussed in an earlier example. Well, even if this dividend is automatically reinvested, you are still responsible for paying tax on that $73 payment. In a nutshell, because you may not notice the dividend income because of the automated process of DRIP investing it can sometimes catch people off guard and result in an unexpectedly high tax bill at the end of the year.

To be perfectly clear, in the vast majority of cases I feel that the benefits of DRIP investing outweigh these downsides, but they're still important to keep in mind.

DRIP investing is a valuable tool for long-term investors

Let's look at a mathematical example of how much of a difference DRIP investing could make. As I'll discuss later on, AT&T (NYSE:T) is one of my favorite dividend stocks, and I own it in my portfolio. To keep numbers round and easy to work with for this example, let's say that I have 200 shares of AT&T.

As of this writing, AT&T stock trades for about $32.00 and pays an annual dividend of $2.00 per share, or $0.50 each quarter. So, my 200 shares will pay me a quarterly dividend of $100.00. For simplicity, let's assume that AT&T's dividend will stay the same for the next few years (although in all likelihood, the dividend will get somewhat larger). We'll also assume that the share price will stay the same.

If I enroll my AT&T stock in a DRIP, my next quarterly dividend of $100 will be used to purchase 3.13 shares of stock, giving me a total of 203.13 shares. Continuing this example over the next two years, here's how my investment would continue to compound:

Dividend Payment

Number of shares before dividend

Amount of Dividend (@ $0.50 per share)

Number of shares purchased through DRIP

1

200

$100.00

3.13

2

203.13

$101.57

3.17

3

206.30

$103.15

3.22

4

209.52

$104.76

3.27

5

212.80

$106.40

3.32

6

216.12

$108.06

3.38

7

219.50

$109.75

3.43

8

222.93

$111.46

3.48

After 2 years

226.41 shares

   

Data Source: Author's own calculations. All figures rounded to two decimal places.

Now let's see what would happen if you didn't enroll your shares in a DRIP but still wanted to build up your AT&T investment over time. Your first $100.00 dividend payment would be enough to purchase three shares of AT&T for $96, but don't forget about commissions. If you're paying a $7 brokerage commission, that first dividend would only be enough to purchase two shares, leaving you with $29 in cash left over.

Here's how this would pan out over two years, making the same assumptions as our DRIP example.

Dividend Payment

Number of Shares

Amount of Dividend (@ $0.50 per share)

New Shares

Cash in Your Account

1

200

$100.00

2

$29.00

2

202

$101.00

3

$27.00

3

205

$102.50

3

$26.50

4

208

$104.00

3

$27.50

5

211

$105.50

3

$30.00

6

214

$107.00

4

$2.00

7

218

$109.00

3

$8.00

8

221

$110.50

3

$15.50

After 2 years

224

     

Data Source: Author's own calculations. "New shares" are based on dividend plus excess cash, less trading commissions. All figures rounded to two decimal places.

Let's compare the two scenarios. Enrolled in the DRIP, you would end up with 226.41 shares worth $7,245.12, and no cash since the DRIP puts 100% of your money to work. Without the DRIP, you would have 224 shares worth $7,168 and $15.50 in cash, for a total of $7,183.50.

So, the DRIP would result in $61.62 more after just two years, $56 of this amount represents the savings from eight commission-free investments, and the rest is from the additional compounding power that comes with putting your entire dividend to work, as opposed to just buying the number of full shares you can afford. And this is without any increases in AT&T's dividend or stock price. Over a period of say, 30 years, enrolling your stocks in a DRIP can result in thousands of dollars in additional gains.

Obviously, this is a simplified example. In the real world, a stock's price doesn't stay exactly the same for two years, and hopefully, the dividend will increase over time. The point, however, is that enrolling in a DRIP puts the mathematics of long-term compounding well in your favor.

How to enroll in a DRIP

If you use an online brokerage, like most investors do these days, enrolling your stocks in a DRIP is generally a quick and easy process. On TD Ameritrade's platform, just to name one example, there's a subhead called "dividend reinvestment" under the "My Account" menu at the top of the screen. Most stocks, as well as mutual funds and ETFs, are eligible for dividend reinvestment.

It's also important to mention that when you enroll in a DRIP, you'll likely have the option of enrolling all of your current and future stock investments or specifying just certain stocks to enroll. For example, if you own five dividend-paying stocks, but don't really want to buy any more of one of them, you can choose to enroll the other four stocks in the DRIP and receive the dividends from the other one in cash.

Your dividend reinvestments are generally complete within a few days of the company's dividend payment date.

I mentioned that your dividends can be used to purchase fractional shares through a DRIP, so there's a couple of points to know about this. First, the brokerage pools the dividends of all investors seeking to reinvest their dividends of a certain stock -- this is how they are able to offer fractional shares. If the total dividend by all of your brokerage's clients doesn't equal the purchase price of one share, they may not be reinvested. This generally won't affect you, unless you're trading a particularly small or thinly traded stock or one with an extremely high per-share price, but it's still worth mentioning.

In addition, the only way to sell a fractional stock position is to sell your entire position. In other words, if you own 35.5 shares of Apple, you can't simply decide to sell 5.5 shares and keep the other 30. In most cases, you would need to enter an order to sell 35 shares, and the brokerage would automatically sell the fractional share in your account.

The best stocks for dividend reinvestment and a few examples

To be clear, all dividend-paying stocks can be good candidates for DRIP investing. However, the benefits of DRIP investing are most apparent when it comes to stocks with steady dividends that grow over time. For this reason, the Dividend Aristocrats index -- that is, S&P 500 stocks with at least 25 consecutive years of dividend increases -- is an excellent place to start your search. The index includes companies such as Coca-Cola, Johnson & Johnson, and Procter & Gamble, which have increased their dividends for 55, 55, and 61 years, respectively.

There's also an S&P High-Yield Dividend Aristocrats index, which features S&P stocks with above-average dividends and 20-year dividend-increase track records, as well as several other dividend stock indices that could be valuable in your search for excellent DRIP stocks.

Just to give you an idea of what I'm talking about, here are two examples of stocks in my own portfolio that I have enrolled in a DRIP and why they make such good DRIP candidates:

First is real estate investment trust (REIT) Realty Income (NYSE:O). Thanks to a low-risk business model designed to produce stable growth over time, Realty Income has one of the best dividend payment records in the entire market. Based on the current share price, the company pays a 5% dividend yield and has increased its dividend a staggering 96 times since its 1994 NYSE listing. What's more, Realty Income also pays its dividend in more frequent monthly installments, which increase the long-term power of reinvestment. A 5% annual dividend yield effectively becomes 5.1% when compounded monthly, and over time, this seemingly small difference can have quite a substantial impact on your returns.

Another great DRIP stock that I own in my portfolio is telecom giant AT&T. With a generous 6.2% dividend yield and a 33-year streak of dividend increases, AT&T has been an excellent stock to take advantage of the power of compound returns. And with a payout ratio (dividends relative to the company's earnings) of less than 60%, there's no reason to believe the streak will end anytime soon. Plus, forward growth catalysts such as the emergence of 5G network technology and the surge in internet-connected devices, AT&T should see significant earnings growth over time.

To DRIP or not to DRIP?

There are valid reasons to enroll your stocks in a DRIP, and there are also good reasons to opt to receive your dividends as cash payments instead.

Specifically, DRIP investing is generally a smart idea for investors who plan to hold their stocks for the long haul, want to compound their investments as effectively as possible, and who want to save on commissions.

However, if you rely on your dividend stocks for income to cover your expenses, DRIP investing might not be for you. Retirees who invest in dividend stocks specifically for income purposes are a good example of people who may be better off not enrolling in a DRIP.

Additionally, if you want the flexibility to invest all of your dividends as you see fit, it could be a smart idea to not use a DRIP. For example, if you have 10 different stocks that each pays an average dividend of $100 per quarter, some investors might rather have that $1,000 every three months to invest in whichever stock they feel is the best value at the time, as opposed to just automatically buying more shares of all 10.

The bottom line is that DRIP investing can be a great tool for long-term investors, but that doesn't mean it's right for everyone. It's a smart move to carefully weigh the advantages and disadvantages before you enroll your stocks in a DRIP.

Matthew Frankel owns shares of Apple, AT&T, Caterpillar, and Realty Income. The Motley Fool owns shares of and recommends Apple and Johnson & Johnson. The Motley Fool has the following options: long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, and short May 2018 $140 calls on Johnson & Johnson. The Motley Fool has a disclosure policy.